What FII inflows in debt mean for your investments

It's not just stock markets which are attracting foreign money. Domestic bond/debt markets, too, have become a favourite of overseas investors. This year till November 13, foreign institutional investors, or FIIs, and foreign portfolio investors, or FPIs, invested a net Rs 1.40 lakh crore in Indian bonds compared with a net outflow of Rs 51,000 crore in 2013. This is more than the combined net inflow of the past five years. This is also more than the net inflow into equities (Rs 91,000 crore).

Higher yields

What is behind this huge FII interest in Indian debt markets? "There are three factors-higher bond yields, improved economic sentiment and anticipation of a fall in interest rates," says Amandeep Chopra, head of fixed income, UTI Mutual Fund.

The yields on 10-year government bonds were 8.22% on November 14. This is much higher than the yields on 10-year bonds of the US (2.36%), Germany (0.8%), Britain (2.17%), Brazil (4.27%) and Japan (0.5%). This is because of easy monetary policies adopted by central banks across Europe, Japan and China. "Globally, US 10-year yields are falling in line with the US dollar Libor, which reflects global liquidity deluge and unsustainably low interest rates. There is a class of investors which chases yields. Indian bonds have been the beneficiary of action by such players," says Deep N Mukherjee, senior director, India Ratings.

Stable currency

A stable rupee (it hasn't moved more than 2-3% in the past six months against the dollar) has also helped. When FIIs invest in India, they look at the cost of borrowing in their own currency, rupee interest rates, exchange rate outlook and hedging cost.

"While dollar borrowing rates have been very low and interest rates in rupees quite high, offering a good 'carry', the steady rupee has given foreign investors the option of not hedging their currency risk and thus get a much larger spread. Thus, steady currency and high interest rates are the two powerful incentives for investing in Indian bonds," says Harihar Krishnamoorthy, treasurer, FirstRand Bank India.

Experts say exchange rate volatility is a worse dampener for bond investors than the currency level. Imagine that a US citizen invested Rs 60,000 in a rupee bond yielding 8% a year. At the time of investment, the US dollar was at Rs 60. Therefore, his investment was $1,000, on which he earned Rs 4,800 (at 8%) as coupon interest. Now, if the dollar is at Rs 63 at redemption, that is, it has strengthened against the rupee, the value of his investment will shrink to $952. This currency loss is offset by the coupon interest of $76. The value of his investment at the end of the year will be $1,028, an overall gain of 2.8%. Thus, sharp volatility in the exchange rate can make returns uncertain, discouraging investors.

Rupee's stability has been helped by improved current account deficit. Rupee has also been stable due to huge net FII inflows into equities. So far this year, over Rs 90,000 crore has flowed into Indian stocks. In 2013, the figure was Rs 1.13 lakh crore.

Rates have peaked

With inflation coming off from 7% a year ago to 1.77% in October, the chances of the Reserve Bank of India (RBI) cutting interest rates have increased. Though the RBI is unlikely to cut interest rates in the near future given its view that high inflation may return if it relaxes its monetary stance any time soon, it is unlikely to increase policy rates.

For investors, it is a good time to buy high-yield bonds to gain from capital appreciation when rates fall. Apart from the above factors, investor confidence in Indian debt (especially government bonds) was renewed after Standard & Poor's upgraded the country's sovereign rating from negative to stable in September.

What are FIIs buying?

Usually, FIIs prefer Indian government bonds. The upper cap for FII investment in these bonds is almost always reached. On November 14, 98% of the $25 billion annual FII limit in government bonds had been used up. Close to 80% of the $5 billion meant for long-term FPIs such as pension funds had also been utilised.

The FII investment cap in corporate bonds is $51 billion, of which only 54% has been utilised so far. With government bond limit exhausted and 45% quota for corporate bonds still unutilised, FIIs may now turn their focus on corporate bonds.

"There is limited interest in lower rated corporate bonds. Unless the bankruptcy regime in India improves, investors will not show much interest in corporate bonds," says Deep N Mukherjee of India Ratings.