FII sell-off in debt market halves

For flows to return, Rs must stabilise and forward premium or hedging costs should fall

Foreign investors have been pulling out of Indian debt markets since June this year, which has led to the rupee’s depreciating by over six per cent since then. Even though bond dealers bought the entire $4.34 billion quota to invest in debt markets on Monday, experts say it means little in the current context, as foreign investors will not commit large sums of money to Indian markets till the currency stabilises.

The currency’s movement, in turn, depends on measures the government and the central bank take. The currency’s current levels suggest that the measures announced by the Reserve Bank of India (RBI) last week have not helped much. Further tightening, announced by RBI on Tuesday, is expected to further push up bond yields and forward premium or the hedging cost because call rates will shoot up. For investors to invest in bond markets, both these levels need to hit equilibrium.

Bond markets are better indicators of the investment climate than equity markets and tend to react much faster. The momentum of sell-off in the market is another key indicator of foreign investor interest in India and that suggests that the sell-off has cooled but not reversed. The average daily sell-off since June 3 has been in the range of $200 million, which has somewhat abated after RBI stepped in and tightened liquidity and raised short-term rates. Although the measures have prevented a further fall in the rupee, the crisis is nowhere near over.

FIIs continue to be net sellers in the debt markets. The good news is that the daily net sell-off has halved to $100 million levels. G Ananth Narayan, head of global markets, South Asia, Standard Chartered Bank, explains: “While the auction was successful, the cut-offs were very low. If we have NRI bonds being announced, that will be positive for the rupee and bonds. The FIIs are just keeping their options open that in case something like that happens. If you look at the cut-offs, it does not seem like a well-bid auction. The actual translation of this auction into flows still remains to be seen because the mood has to stabilise and people have to see some comfort.”

While the pressure of selling has abated somewhat, foreign investors may not start buying bonds in a hurry despite the successful completion of bond limit auctions held on Monday. Fresh investments will depend on how bond yields and forward premiums move. The forward premium is nothing but the hedging cost incurred by the foreign investors. So after the central bank’s intervention, 10-year bond yields may have breached the 8 per cent levels, the forward premium has also inched up from 5.5 per cent in June to 8 per cent in July. This offsets benefit of higher yields. Ajay Manglunia, senior vice-president (fixed income), Edelweiss Securities, says: “When FIIs invest in bonds, they need to hedge on the currency risk. Currently, the hedging cost has gone up due to the weak rupee. If the hedging cost comes down, the market will become more attractive. We will see more investment if the hedging cost becomes more competitive.”

Bond limits that FIIs buy are valid for 30 days. The major portion of the auction held last month was also subscribed, however, it did not stop the FIIs from selling. The yields have risen sharply this time, compared with last month due to which the auction held on Monday was fully subscribed. In terms of yields, now the bonds have become more attractive.

For FIIs, the price they are paying to acquire these bonds are very low. Those who are buying these bonds are mostly the foreign banks.