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Foreign funds may cash out of India's bond market on index inclusion delay – analysts

FILE PHOTO: Illustration photo of an India Rupee note

By Dharamraj Lalit Dhutia

MUMBAI (Reuters) - Foreign funds will continue to trim their holdings in India's government debt after J. P. Morgan delayed the inclusion of the country's bonds in its global index, sparking a further rise in yields, analysts said.

"Since mid-September we have seen outflows on expectations that the index inclusion may not materialise in 2022," Nagaraj Kulkarni, co-head for Asia rates strategy, excluding China at Standard Chartered Bank said. "There is still scope for further outflows from bonds."

Earlier this week, J. P. Morgan said India remains on the radar to be included in its influential emerging market local currency debt index after a review, dashing hopes that Asia's third largest economy would be added this year.

Some investors cited investment hurdles, "including a lengthy investor registration process and the operational readiness required for trading, settlement and custody of assets onshore," J. P. Morgan said in its statement.

Indian government bonds suffered a selloff, with the benchmark yield rising nine basis points on Thursday in the aftermath of this development. It was last trading at 7.46%.

Foreign investors and banks had turned buyers of Indian bonds in July-September, solely on bets that India may be included in global indexes, with some foreign brokerages predicting an announcement after a review this month.

Foreign investors had made a net purchase of 100 billion Indian rupees ($1.21 billion) of bonds under the Fully Accessible Route, or FAR, in July-September.

Bonds under FAR do not have any investment limit.

Alongside a delay in index inclusion, rising U.S. yields as well as elevated oil prices will also hurt investor appetite for local debt, some economists said.

"There are more risks than one on bonds. First of all, hawkish Fed and thus elevated U.S. yields are likely to push up domestic bond yields," Swati Arora, senior economist at HDFC Bank said.

Besides, Arora pointed to the chances of RBI taking the repo rate to 6.50% by March from 5.90%. FOCUS ON SUPPLY

With index inclusion bets crumbling for the near term, market participants will now shift focus to the heavy supply of bonds set for the rest of this fiscal year.

"Supply pressure is likely to exert upward pressure on bond yields," Standard Chartered Bank's Kulkarni echoed.

The benchmark bond yield will trade in the 7.50%-7.75% range in this quarter, he added.

India's federal government aims to borrow gross 5.92 trillion rupees through bonds in October-March, while states plan to raise 2.53 trillion rupees in December quarter. The states' borrowing could further go up in the last quarter of the fiscal year.

"Heavier state debt supply and a marginal shift in composition towards the longer segments could weigh on 10-year and beyond tenors, Ashish Agrawal, head of FX and EM macro strategy research, Asia, at Barclays said.

"Demand is likely to stay defensive, as investors factor higher funding rates and residual tightening risks," Agrawal added.

Meanwhile, a mismatch in supply and demand, along with tighter liquidity conditions will weigh on bonds, HDFC Bank's Arora said.

($1 = 82.3975 Indian rupees)

(Reporting by Dharamraj Lalit Dhutia; Editing by Dhanya Ann Thoppil)