Pricing potential currency depreciation
Scenario analysis of the impact of INR depreciation on Indian equities and bonds
At the time of writing (17 Aug ‘ 23), the INR is trading at or close to a new low v/s the USD. A quick comparison of emerging market (EM) currencies (FX) reveals that India, China, South Africa and Taiwan are the weakest across the EM FX landscape and all at their lows despite the Dollar index (DXY) still being ~ 10% off its recent highs. You can read more about this here.
In such a situation, it would be useful to evaluate the impact of a potential depreciation in the INR on Indian bond and equity markets.
Current spread between US & Indian bonds v/s historical premia
To evaluate that, let’s start with the spreads between bond yields for US and Indian government bonds across maturities (at the time of writing)
Since the financial crisis of 2008-09, the INR has been depreciating at ~ 3.5% to 4% per annum.
=> The annual premium for hedging the INR v/s the USD would be equivalent to the extent of depreciation i.e. 3.5 to 4%.
=> This spread i.e. 3.5 - 4% would typically be reflected in the term premia of Indian govt. bonds over US govt. bonds of an equivalent maturity.
Since currency depreciation doesn’t happen in a straight line, the forward premia for hedging the INR has varied between 3% in normal situations to 6% plus during periods of stress (when folks rush in to buy hedges)
As seen in the table above, the current bond yield spreads don’t reflect the historical risk premiums. There could be many reasons for this
The rapid normalization of rates in the US from a decade of suppressed yields may have temporarily distorted historical spreads.
Yield curve activity in the US (issuances in the short end and buying in the long end) resulting in an inverted yield curve in the US and a flat curve in India may have distorted yield spreads across maturities.
Maybe we are at the start of a structural cycle where bond yield spreads as well equivalent FX risk premia between the US and India compress as India gains in weightage and relevance globally.
The inflation differential between India and the US maybe changing as India increases domestic manufacturing capacity.
De-dollarization may have started and is being reflected in a lower premium for the US$ v/s what it has historically enjoyed.
All of the above maybe partly true and may have been contributing factors.
How would bond yields react if FX forward premia changed
To analyze this, we can do an exercise of normalizing the risk premia for the forward cover on the INR and even take it into potential stress scenarios.
For simplicity, we take an average of the yields for US and Indian govt bonds shown in table above i.e. 4.77% for US bonds and 7.17% for Indian bonds.
=> A normalizing of FX forward premia could cause Indian bond yields to increase by ~1% and a stressed scenario could double that.
Important to note here that the above may not happen especially if India is changing structurally but short term market reactions can never be ruled out.
How would a change in bond yields impact investor behavior
At a headline level, when yields increase, investors will typically seek fixed income and lock into higher rates. This behavior is more pronounced in wealthy investors as they have a large existing corpus and the need for steady returns and capital preservation takes precedence over wealth creation.
For this segment, the big change post Mar ‘23 has been that the effective tax rate on debt moved up from ~10% to 35% plus and hence changed the potential attraction of fixed income v/s equities (10 - 15% tax on capital gains).
So we evaluate the above scenario of different yields on a post tax returns basis and hence calculate equivalent post tax returns on equity.
The above table gives the post tax returns which would make an investor indifferent between equities and bonds. (in reality the investor may demand a higher risk premia for equities in a stressed environment). Inverting the post tax yields on equity gives a theoretical fair value P/E level for the market.
The current P/E of the market is closer to the 19 - 20x level.
The above table could serve as a reference for how market multiples can behave in the event of a bond yield re-pricing driven by a normalization (or stress scenario) for forward premia on the INR v/s USD.
Please note - this is not an investment advice or recommendation. The above scenarios may not play out at all. The objective is to do a what-if analysis.