JP Morgan’s Bond Index Inclusion: What It Means for India's Bond Market.

Introduction

JP Morgan has recently announced that Indian bonds will be a part of the GBI-EM Global Index, which accounts for around $213 billion, and Indian bonds will be given a weightage of about 10%, which means around $21 billion dollars is accounted for by Indian Bonds. This inclusion becomes effective from June 28, 2024, and 1% will be increased subsequently for the next 10 months.

What Are Government Bonds and How Do They Work?

To understand the bond market, let us ask ourselves… What are Government Bonds? These bonds are just a way for the government to borrow/raise money from the general public, promising to return the principal amount with an additional interest. To simplify it, you could think of government bonds as a loan the government takes from you at a particular interest rate.

The Relationship Between Bond Prices and Interest Rates

Now, let’s look at how bond prices fluctuate and their relationship with interest rates. Basic economics dictates that an increase in demand leads to an increase in price. Thus, if the demand for a bond increases in the market, the bond price will increase…just like the stock market, and then subsequently as the bond prices increase the interest rates decrease. To understand the concept behind this relationship, we must understand the term - “Annual Coupon Payment.” This term refers to the promised annual interest paid by the government to the individual who buys the bond, irrespective of the current price. For example, Person A buys a bond of Rs. 1000 at an interest rate of 6% P.A. The annual interest payable by the government is Rs.60. This is also called the Annual Coupon Payment. Now consider the bond price goes up due to increased demand, let’s say it becomes 1100, the interest rate will decrease so as to adjust itself to maintain the Annual Coupon Payment Amount. Thus, the interest rate shall decrease and become 5.45%. This shows us that there is an inverse relation between bond prices and interest rates.

Exploring the Yield Curve and Its Types

Now let's move on to understand the yield curve of a country. A yield curve gives us the relationship between the maturity period and the interest rates on the bonds. There are types of yield curves:

• Upward Sloping Yield Curve: A Sign of Economic Growth

• Flat Yield Curve: Indicators of Economic Uncertainty

• Inverted Yield Curve: Warning of Economic Recession

Nature of Yield Curves

1. Upward Sloping Yield Curve: A Sign of Economic Growth

   This curve represents a typical scenario in a growing economy where longer-term bonds have higher yields than shorter-term bonds, indicating expectations of future growth and inflation. This type of curve also suggests people trust in the future of the country and expect good returns. One additional significance of this curve is that it shows how easy it is for organizations to issue short-term bonds at lower rates (Hint: To understand this point, look at it from the perspective of an organization looking to raise money. With lesser interest rates, raising capital comes at cheaper rates).

2. Flat Yield Curve: Indicators of Economic Uncertainty

   This curve shows uncertainty about the future of the country's economy. It also suggests that borrowing, be it short-term or long-term, comes at the same price.

3. Inverted Yield Curve: Warning of Economic Recession

   This curve depicts a scenario where shorter-term bonds have higher yields than longer-term bonds. This often represents that the country's economy is at a recession stage. However, it is important to note that in some cases the central banks may introduce some monetary policies to make the yield curve inverted. This is mainly done to tackle inflation.
   

GREAT! Now that we have an understanding of how bond prices and the yield curve work, let us try to analyze the JP Morgan situation.

The Role of JP Morgan Bond Index on the Indian Bond Market

One of the most obvious and at the same time the most important effects is going to be the flow of foreign funds into the Indian market. Where do these funds come from? So, there is something known as passive funds. What these funds basically do is that they invest blindly according to these indices and try to replicate them. Which means more the inclusion of Indian bonds, the more the investment from these funds. Apart from these, there are various other foreign investors that actively follow these indices and invest according to them.

Foreign Investment Surge and Its Effects on Bond Prices

To put it simply, foreign investment and the demand for Indian bonds will increase drastically. This increase in demand will eventually result in the increase of prices of these bonds.

Analyzing the Flattening Yield Curve in the Context of External Investments

Now, coming to the effect on the yield curve. As the prices increase, the interest rates on the bonds are going to decrease leading to the flattening of the curve. Wait a sec, isn’t flattening of the curve a bad sign? Here comes the interesting part of the discussion. However, in situations like these where there is an external investment or large demand that leads to the flattening of the curve, it doesn't signal an economic slowdown. The flattening of the curve on its own without external influence is the signal of an economic slowdown. This is one of the most crucial parts of understanding yield curves. People often just look at the nature of the curve and predict how the economy of the country is. However, from this case study, we understand that one cannot analyze yield curves without understanding the factors that are affecting them at that time.

Impact of Indian Bonds Inclusion in JP Morgan's GBI-EM Global Index

Conclusion:

In conclusion, the inclusion of Indian bonds in JP Morgan’s GBI-EM Global Index will significantly boost foreign investment and demand for Indian bonds. This surge will drive up bond prices and lower interest rates, flattening the yield curve. However, this flattening results from external investment, not

an economic slowdown.