FII debt inflows outpace equity

Trend may continue through the calendar year as there is greater headroom for investment in debt than equity

Foreign portfolio investors are the sultans of Indian equities, given that they own 22 per cent of the BSE 500, second only to Indian promoters who control 28 per cent of the universe. A quarter of India’s largest companies are owned by foreign institutional investors (FIIs) and the value of their equity ownership stands at a staggering $315 billion. Economic growth has halved during the past five years - calendar year 2014 is no different - but there is an interesting shift this year. Foreign portfolio investors have pumped in $13.4 billion into debt and $12.2 billion into equities. For the first time, FII flows into debt have surpassed that into equity. Strategists believe this signifies the deepening of India’s financial markets.

Equities have always been the preferred investment for FIIs against debt. Since 2010, FIIs have pumped in $39 billion into debt against a staggering $86 billion into equities. However, this year could be different if debt flows continue to outpace equity flows. So far, there has been a reluctance to open the Indian debt market but with the fiscal condition improving and currency stabilising, treasury heads expect the flows into Indian bonds to remain strong if debt limits continue to open up. Anindya Dasgupta, treasurer at Barclays, says: “There is an appetite for Indian paper and if bond limits continue to open up, more flows could come in. However, the opening  of the Indian debt market is likely to be gradual.”

Bank of America Merrill Lynch expects the government to raise FIIs’ on-auction G-Sec limits by $5 billion to $30 billion, doing away with the separate limit for sovereign wealth funds. This month, FIIs hit 97.4 per cent of their limits as they pumped  $2.6 billion into Indian gilts. Opening  limits might help Reserve Bank of India build a stronger war chest to combat a contagion later next year, once the US Federal Reserve hikes interest rates.

Higher flows into Indian debt are also a sign that India’s financial markets are broadening with new tilts. Says Citi, “FII debt flows are accelerating, at $13.4 billion year-to-date, they exceed equity flows, and there’s more investment headroom. This is broadening India’s markets and with new tilts should continue to liven up.”

With not much headroom left for FIIs in the equities space, with them nearly hitting the permissible limits, the focus is now shifting to Indian debt. This shift is perceptible as this is the first time debt flows have outpaced equity inflows and the trend might continue through the year, as FIIs have more headroom to invest in debt than in equities.

For three years, FII inflows into equities have been very strong ($24 billion in 2012 and $21 billion in 2013) but the massive swing this year has been in debt. For the first time since 2000, FII flows into debt have crossed $10 billion. For the full year, FII flows into debt were at $10 billion in 2010, while FII flows into equity that year were at $29 billion. According to Citi, there is significant headroom left for FII investments in debt. While some of this money might leave the country if interest rates rise in the US from mid-2015, treasury heads believe interest in Indian debt would continue, with global investors viewing India as an opportunity as a portfolio diversification strategy. That India’s markets are deepening is also a source of confidence.

The equity bulls might not agree, given that there are a large number of OFS (offer for sale) lined up by the government in listed public sector companies, but equity strategists believe the FII flows into equities in the cash market have already eased and the junk rally might not last at all. Gaurav Mehta of Ambit Capital says: “The past few months have seen ‘junk’ shoot through the roof. Historically, such periods of ‘junk’ outperformance are usually short-lived and a deluge of QIPs (qualitative institutional placement) is often the trigger deflating their rally. We have been flagging a similar deluge since early July and believe the past month’s price action may have just marked the beginning of the end of junk’s outperformance for the foreseeable future.”