The Indian bond market has seen its affair with foreign investors swing in both directions over the last few months. From being darling of foreign investors, it has now become one of the many options. In a way, this also is a commentary on the Indian bond market, which is yet to mature to provide a credible alternative to investors.
The attractiveness of Indian bonds
Over the last few years, India had lost its position in the eyes of investors. However, with a new government in place, the outlook on economy and political stability has improved. The season of high growth that India lost over the last three years is expected to come back riding on the policy initiatives of the new government. Owing to this, foreign investors showed high interest in Indian bonds and bought in bulk.
The other reason is the high yield that the Indian market offers. In an era of close to zero interest rate, the yield in developed economies - from where most of the foreign investors hail - hovers at around 1-2 per cent, while India offers a yield of more than 8 per cent. Naturally, bond investors started looking at the Indian bond market with interest. Initially, they invested in government securities but later started to invest in high-yield corporate bonds that offer better rates than the government securities.
The preferred corporate bonds were Power Finance Corporation (PFC), HDFC Bank, Axis Bank, ICICI bank, and firms such as Power Grid Corporation of India. The difference in yield of these bonds over government securities is about 30-40 basis points, leading to extra gain of 0.3-0.4 per cent on annualised basis.
The rush to invest in the Indian bond market was so high that the Foreign Institutional Investor (FII) investment limit of $30 bn put up by the RBI was exhausted in no time. The FIIs then turned to corporate bonds, where the investment limit is $51 bn. This, too, saw a rapid demand. Overall, FIIs were investing $1.5-2 bn every month in the bond market.
FIIs in the current Indian bond market
The current scenario is not as bullish as it used to be. Indian bonds are slowly losing their attractiveness for FIIs. There are several reasons for this.
Some FIIs have been instructed to invest only in government bonds, and this has led to lowered interest in corporate bonds. Secondly, the gap in yield between corporate bonds and government securities is narrowing. Corporate bonds also have less liquidity than the government bonds, and this has further added to the woes of the Indian bond market. The silver lining, however, is that domestic investors have bought most of the corporate bonds and picked up some of the slack.
Significantly, RBI has reduced interest rates in the last one year by a whopping 125 basis points, leading to a fall in the yield of bonds. As the yield goes down, investors lose interest in the bond. At the same time, FIIs also have to hedge against currency fluctuation leading to expenses, which reduces their effective returns.
Additionally, US bonds yields have improved. There is also talk about raising the interest rates in the US. The Fed chairperson has hinted that the stimulus packages or quantitative easing would be tapering off very soon. If this happens, India will see more outflow of investments to US bonds.
Both factors, the lowering yield in India and rising yield in US, have resulted in the difference of less than 5 per cent in respective yields, which use to be 8 per cent or more.
As it stands today, the RBI has shown its willingness to cut the interest rates further because the inflation is at a manageable level, which was the prime objective of RBI. We may see further interest rate cuts in time to come. The possibility of a further 50 basis point rate cut in the next one year is highly likely. This would dent the bond market further.
What next
The current situation cannot be deemed entirely unfavorable for the Indian bond market. It may not see the rush of FIIs, but is anticipated to remain stable. A lot depends on the Fed action on US interest rates. If the rates are increased, the bond market will suffer further outflow.
The good news is that many foreign investors are eagerly awaiting the government’s next actions on the policy front. If the government gets its act together and guides the economy in the right direction, there will still be enough investors investing in Indian bonds to compensate for the outflow.
India provides and will continue to provide huge opportunities for bond investors in terms of volume. There are very few markets in the world that can absorb such big flows of FII investment, provided India gets its growth story to stay on the right track.
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