India’s biggest banking scandal is likely further cloud foreign investor sentiment on local currency Indian bonds that are already performing badly. But the allure of high relative yields is likely to prove too strong for international investors to resist for long, claim fund managers and fixed income market specialists.

On February 14, state-owned Punjab National Bank (PNB) announced to Indian stock exchanges that it had discovered Rs113.9 billion ($1.8 billion) in fraudulent and unauthorised transactions.

Diamond jeweler Nirav Modi and Mehul Choksi, the owner of Gitanjali Gems (a nephew-uncle duo), are alleged to colluded with PNB executives to create a string of fraudulent transactions over a period of seven years that local media dubbed as “India’s biggest banking scandal”.

Vikram Aggarwal, a London-based assistant fund manager for fixed income at Jupiter Asset Management, said the scandal will worry investors as it suggests poor control at the banks. “This could lead to reduced appetite for securities issued by state-owned banks and increases concerns about governance standards,” he told AsianInvestor.

That sentiment was shared by Ajay Manglunia, executive vice president at Mumbai-headquartered Edelweiss Financial Services, which has interests in asset and wealth management as well as investment banking.

In the days after PNB, India's second-biggest public sector bank, made its announcement, bond securities of the state-owned bank climbed by up to 20 basis points, a media report said. The country’s benchmark 10-year government bond yield also moved higher from 7.49% on February 14 (the day the PNB story broke), reaching 7.68% on February 26, according to Bloomberg data.

“Investors will be assessing to see if there could be a similar situation in other state-owned banks,” said Manglunia. 

On February 20, ratings agency Moody’s Investor Services placed PNB’s local and foreign currency deposit rating (Baa3/P-3) and foreign currency issuer rating (Baa3) under review for a downgrade.

This is likely a short-term reaction, argued Alka Anbarasu, Singapore-based banking sector analyst at Moody’s. She noted that there is no data to indicate that PNB’s fraud could infect India’s broader banking system.

“For now, we are treating it as an idiosyncratic issue,” she told AsianInvestor.

In its release, the ratings agency said it assumes a very high probability the government will end up supporting PNB, to prevent it falling into major financial distress. “Any indication that government support has diminished beyond what Moody’s anticipates in this rating action could also lead to a ratings downgrade,” it noted.


The likely backing of New Delhi should provide comfort for foreign investors. They invested $22.3 billion in Indian debt securities in 2017, after pulling out a net $6.6 billion 2016, according to data from the National Securities Depository Limited (NSDL).

That positive trend has continued in 2018: until February 26, foreign investments into debt markets totalled $1.5 billion—almost three times as much as equivalent flows into equity markets ($583 million).

Jupiter AM’s Aggrawal noted that appetite remains high among foreign investors, with foreign investments into Indian debt having inched closer to the maximum permissible limit. Up to 98.77% of the available Rs1.91 trillion ($29.5 billion) allocation for central government securities has been used up by foreign investors, according to NSDL data.

This foreign interest has not been able to stem a difficult period for Indian bonds. Since September 2017, the yield on the government’s benchmark 10-year bond has jumped by around 110 basis points, according to Bloomberg data.

A set of concerns have led the country’s debt markets to be the worst performing among emerging market peers this year, according to Edelweiss data, over a multitude of growing concerns such as rising inflation, higher budget deficit, and hardening oil prices (India is a net importer of oil). 

Jupiter AM’s Aggrawal noted that one issue concerning investors is that there has been less fiscal consolidation than expected. India's fiscal deficit is expected to come in at 3.5% of GDP for the financial year ending March 2018, up from the original estimate of 3.2%. For financial year 2019 (April-March), the deficit is forecast at 3.3%, higher than markets anticipated. That means the government will need to raise more money from bond markets.

In addition, inflationary pressures are driving expectations of future rate hikes. Consumer price inflation shot up to a 17 month high of 5.21% in December 2017, although it cooled slightly to 5.07% in January, according to media reports. However, that is still higher than the RBI’s medium term target of 4%.

"Looking at the way bond yields have moved, it seems like the market is pricing in about two rate hikes this year,” said Kotak AM’s Iyer. The benchmark policy repo rate is at 6%.

Added to all this are concerns over the appetite of domestic lenders for government bonds. They are the largest buyers of government securities but liquidity situation has grown worse over the past six months why, largely because of stressed assets on their loan books. This is restricting their ability to buy bonds and likely exacerbating the yield rise, Jupiter AM's Aggrawal said.

Viral V. Acharya, the deputy governor of the Reserve Bank of India, added to these concerns in a speech on January 15 when he suggested that Indian banks were highly exposed to government securities.

“The size of banking sector’s balance-sheet exposure to government securities, and hence, its interest rate risk, is high in an absolute sense, and is relatively elevated, when measured in proportion to total assets, for public sector banks relative to private bank,” he said.

That has left concerns about the outlook for Indian government bonds in the next fiscal year, starting on April 1.

“The biggest worry for bond markets in the next financial year is who will buy the gross supply of about Rs6 trillion in government securities that will come into the market,” said Lakshmi Iyer, chief investment officer for debt and head of products at Kotak Mahindra Asset Management.


While investors holding investments in Indian bonds will have suffered some mark-to-market losses because of the recent yield spike, the expansion of yields to over 7% on 10-year government bonds is likely to encourage foreign investors to consider new investments, according to experts spoken to by AsianInvestor.

Edelweiss's Manglunia said that level of return will keep offshore interest in Indian bonds high, even if yields widen a little further in coming months. 

"Given the extremely attractive carry of 7% and a relatively stable currency in the past few years, Indian local bonds remain a good total return opportunity,” he said.