Why are FIIs selling equities and investing in Indian bonds? Murthy Nagarajan of Tata Asset Management explains

The year 2024 has been a great one ear for the Indian bond markets, with several major milestones achieved—such as the inclusion of Indian bonds in JP Morgan and Bloomberg global bond indices and S&P upgrading India’s credit rating outlook from ‘stable’ to ‘positive,’ which is likely to further boost the Indian bond market in coming years.

Attracted by the robust Indian economy and an expanding bond market, foreign investors are increasingly focusing on Indian bonds. Data from NSDL show that foreign portfolio investors (FPIs) have invested heavily in Indian bonds. As of December 27, 2024, FPIs have invested Rs 1.55 lakh crore in Indian bonds in 2024 so far.

On the other hand, Indian equities saw a modest inflow of just Rs 1,656 crore from FPIs during this period. However, until November 30, FPIs were net sellers in Indian stocks.

In an insightful conversation with Business Today, Murthy Nagarajan, Head of Fixed Income at Tata Asset Management, discusses key market trends and outlooks. He shares his views on the impact of the US Federal Reserve's recent decisions on the Indian market, FPI investments, the risks facing Indian bonds, and the role of fixed-income investments for low-risk investors. Nagarajan also provides a detailed forecast for 2025, including the outlook for Indian bonds, the rupee, and expected interest rate movements. Edited excerpts:

Q) What could be the impact of the Fed's decision on the Indian market?

The US Federal Reserve has cut rates by 25 basis points as expected and adjusted its rate cut projections from 100 basis points to 50 basis points. The Federal Reserve Chairman’s press conference was hawkish, as the focus shifted from supporting growth to controlling inflation. The Federal Open Market Committee (FOMC) members now expect CPI inflation for next year to be 2.5% instead of 2.1% in their previous projections. They now anticipate the CPI to reach the 2% target only by 2027.
The dollar index, which measures the movement of the dollar against six major currencies, moved above 108 levels. US ten-year yields rose above 4.50% due to expectations of a slower pace of rate cuts and strong economic growth in the US.
The Indian rupee is trading above 85 to the dollar and is expected to settle around 85.50 to 86.50 in the coming months. The Chinese yuan has depreciated by 2.7% against the dollar, and the rupee's movement must be seen in this context. Indian bond yields are trading in the 6.75% to 6.80% range and are expected to remain within this band.

Q) How can senior citizens with a low-risk appetite achieve higher returns than bank FDs by investing in bonds?

Currently, the yield to maturity of corporate bonds and short-term bond funds that invest in high-quality papers is comparable to the FD returns offered by banks. Investors in these funds have the opportunity to benefit from capital appreciation in the coming year, in addition to high accruals from these funds.
 
Q) What are the key risks you foresee regarding Indian bonds?

The key risks include geopolitical instability and the economic fragmentation of global supply chains.
 
Q) Why are FIIs selling equities and investing in Indian fixed income?

FIIs in equities are finding better opportunities in global markets due to attractive valuations. Indian companies' results have been underwhelming, and there are expectations of earnings downgrades in the coming year. Fixed income, as an asset class, is offering high returns in nominal terms. India’s macroeconomic picture, characterised by a lower fiscal deficit and decreasing debt-to-GDP ratio, contrasts with trends in developed markets. Other emerging markets are struggling due to high inflation and low foreign exchange reserves. The expectation of India being upgraded in the coming years due to high growth and a lower fiscal deficit is strong. The Indian rupee has outperformed other currencies this year and is expected to depreciate only nominally in the coming years. This has led to increased flows into Indian debt markets.

Q) What could be the impact of rupee depreciation on Indian bonds?

According to the RBI, currency depreciation has a marginal impact on CPI inflation. The bigger impact on inflation is expected to come from oil prices, which are forecasted to remain weak due to slower growth in China and Europe. In an orderly manner, currency depreciation is not expected to have a significant impact on Indian bonds.
 
Q) In the current market situation, which types of bonds should Indian investors focus on?

For a six-month horizon, gilt funds should be preferred due to the front-loading of rate cuts. A tactical call can be taken on gilt funds.

For periods above six months, investors should focus on corporate bond funds and short-term bond funds with high-quality portfolios and higher accruals.
 
Q) What is the market outlook for the next year regarding the Indian economy and bond markets?

India’s growth has been affected by lower government spending and recessionary trends in the global economy. However, government infrastructure spending is picking up, which should boost growth. Rabi production is expected to be good in the coming months as temperatures have cooled and reservoir levels are at 82% of capacity. The growth-inflation mix, which has been adverse due to higher food inflation and lower growth, may reverse in the coming months. Core inflation, which excludes food and fuel, has remained below 4% for the past nine quarters.

The RBI’s February monetary policy is expected to project CPI inflation at 3.7% for the next year, which is below the 4% target set by the RBI. Growth next year will require policy support, as consumption demand and private investment are weak. This is reflected in the sales numbers and management commentary from companies. The RBI is expected to cut interest rates by 75 basis points in this easing cycle, as real rates (the difference between repo rates and one-year-ahead CPI inflation) are above 2.5%. The RBI targets a real rate of around 1.5%. Ten-year yields are expected to trade between 6.40% and 6.60% in the coming year.