Investors are ignoring credit risks in the Indian market as they pile into bonds, betting that economic and legal reforms may result in a rating upgrade, according to Babson Capital Management.
Local-currency government bonds are rallying for a ninth month, sending 10-year yields to the lowest level since September 2009. Dollar-denominated high yield notes from Indian companies have returned about 19% so far this year, the most in seven years for comparable periods, according to a Bank of America Merrill Lynch Index.
Investor optimism on Prime Minister Narendra Modi’s ability to push through reforms was cemented this month when lawmakers unanimously approved the creation of a national sales tax that’s been a decade in the making. Moody’s Investors Service said the credit implications of the new levy would be limited in the short-term and more controversial policy changes would probably see slower progress.
“Investors have high expectations from the Modi government, which is reflected in the tight valuations of Indian bonds and implied market expectations of a rating upgrade,” Brigitte Posch, the London-based head of emerging-market corporate debt at Babson, which managed $243bn globally at the end of June, said in an e-mail interview.
“Strong investor appetite for Indian paper has resulted in limited differentiation between fundamentally strong and weak credits.”
Foreign holdings of Indian government and corporate debt declined by Rs10bn ($150mn) in the four days through last week, set for a second weekly drop, data compiled by Bloomberg show. The yield on benchmark 10-year sovereign notes rose one basis point to 7.09% in Mumbai last week.
The government has said the goods-and-services tax could add as much as 2 percentage points to economic growth, which in 2015 was already the fastest among major emerging economies.
Moody’s ranks India at Baa3 while S&P Global Ratings and Fitch Ratings have the country at BBB-, their lowest investment grades. While India is heading in the right direction, the pace of progress has disappointed, said Posch. Boosting investment, reorganising the banking sector and fixing non-performing loans will be a big challenge for the government given it lacks a majority in the upper house of parliament, she said.
“India needs urgent reforms to boost investment, especially into infrastructure and industry,” she said. “The government needs to look beyond its small capital injection this year to remove the legacy NPLs as well as encourage consolidation in Indian public banks to create a banking sector which can support India’s growth objectives.”
The industry’s gross bad-loan ratio jumped to 7.6% at the end of March, according to the Reserve Bank of India’s Financial Stability Report in June. 
That’s a 13-year high. The proportion of stressed assets, which include restructured and soured loans, to total advances was the most in 16 years.
The deferral of a coupon payment last month by Dhanlaxmi Bank that was prompted by an inadequate capital measure flags mounting risks as Indian banks come under pressure, Fitch Ratings said in a report on Friday. That was the first time that investors in Indian banks had to forgo interest on a capital instrument, Fitch said. Babson Capital continues to invest in private-sector banks and better-managed state-owned lenders, Posch said, declining to say which ones. 
A slowdown in real estate and overcapacity mean the sector is not compelling versus peers in Asia, while regulatory changes could pressure companies in the telecommunication, media and technology space, she said.
“Spreads for Indian credit and the emerging-market sector broadly continue to be distorted by the loose monetary policy environment and hunt for yield,” Posch said. “While we are constructive on India as a long-term story and are involved in select opportunities, we remain cautious in the near-term.”