FPIs keep debt market bets steady despite narrowing bond yield gap

Spread between Indian and US 10-year bond yields at 3.14%, narrowest in over a decade

Despite the narrowing spread of yields between the benchmark 10-year Indian government bond and the 10-year US Treasury bond, foreign portfolio investors (FPIs) are continuing to invest in the domestic debt market this year -- a trend backed by a stable currency and a less volatile bond market. FPIs have been net buyers in the debt market in 2023 so far, marking the first time since 2019.

The yield spread between the 10-year Indian government bond and the 10-year US Treasury note stood at 3.14 per cent on Tuesday – the narrowest in over a decade.

Market participants said investors were focusing on the absolute return at the moment, rather than the spread.

“Many overseas investors perceive that while investment into the country carries the currency risk, the rupee depreciation may not be at a level that returns may turn negative over a period,” said Gopal Tripathi, president & head of treasury at Jana Small Finance Bank. “Investment by foreign investors in the debt market is happening now even when the yield differential is low. But the scale of such investment is small,” he added.

The rupee was largely stable in 2023, depreciating 0.12 per cent so far, as compared to 2022 when the Indian currency weakened more than 10 per cent following the war in Europe and interest rate tightening in advanced economies. The yield on the 10-year government bonds has declined 17 basis points (bps) in 2023.

Even though FPIs have been net purchasers, they have scarcely utilised the Reserve Bank of India’s established thresholds for government and corporate bonds. Eligible FPIs had only made use of 29.5 per cent of the specified ceiling of Rs 2.68 trillion for central government securities as of Tuesday. Similarly, the utilisation of the upper limit of Rs 6.68 trillion for corporate bonds was even more minimal, standing at 15.34 per cent.

Some market participants believe that the inflows might reduce going forward. “Because the currency was stable, the interest gap, which is at a low level, was not being eaten into by the depreciation of the currency. Now that the currency has depreciated, these returns will definitely be eaten into,” Indranil Pan, chief economist at YES Bank, said. “Overall, as far as macro stability is concerned, there can be some fears that inflation will be on the higher side. All these factors might not lead to outflows, but there will be a pause in the inflows we are witnessing,” he added.

Typically, a wider spread makes Indian bonds more attractive to foreign investors, as the potential return (yield) from these bonds is higher than that of US Treasury bonds. A narrow yield spread indicates that the potential additional return from investing in one type of bond over the other is reduced; hence foreign investors choose to invest in safe-haven assets.

Investors acquired Indian government and corporate bonds amounting to a total of Rs 21,831 crore in 2023 until Monday, according to data from the National Securities Depository Limited. With the exception of March, FPIs were net buyers of Indian debt every month this year. FPIs' debt inflow reached its highest in June, standing at Rs 9,178 crore, marking the highest monthly inflow in the current calendar year.

FPIs emerged as net purchasers of Indian debt for the first time in a span of four years. The most recent instance of FPIs being net buyers was recorded in 2019, when they invested Rs 25,882 crore in bonds.