Worry not, FIIs will not pull money out of the Indian debt market

FIIs selling government bonds and corporate bonds is a short term reaction to expectations of the US Federal Reserve (Fed) removing monetary stimulus. The discontinuation of bond purchases by the Fed can lead to dollar strengthening and rising dollar funding costs that is negative for an FII holding Indian Rupee (INR) bonds

The cost of Libor funding for the FII goes up leading to lower “carry”, which is the difference between the funding cost and the government bond yield. A strong dollar leads to rupee depreciation and this affects the value of the rupee bond holding of the FIIs.

[caption id=“attachment_851429” align=“alignleft” width=“380”] Reuters[/caption]

FIIs have sold $2 billion of INR debt over the last fortnight and there is worry that further FII selling will lead to bond yields going up and INR falling further. Ten-year government bond yields are trading at 10bps higher from lows while the INR is trading at close to all time lows.

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Will FIIs continue to sell INR debt or will they come back into the market once the global volatility is over? FIIs have bought $7.2 billion of INR debt in the period April 2012 to May 2013 and selling $2 billion is natural given global volatility in rates with ten year US Treasury yields higher by40bps over the last one month. FIIs in fact could sell more if volatility continues in global markets. However, FIIs will not sell all their debt holdings and will in fact come back into INR debt as global volatility subsides.

The reason why FIIs will continue to invest in INR Debt is the fact that the rate arbitrage is high between USD yields and INR yields. On a fundamental basis, the US Treasury yield curve can only rise while there is ample scope for the government bond yield curve to fall. The difference between the ten year US treasury that is trading at 2.10% yields and the ten year government bond that is trading at 7.20% yields is 510bps. Yes the spreads have come off from levels of 670 bps over a fourteen month period but at 500bps levels there is enough scope for the spreads to come off further.

The US markets are factoring in economic growth prospects and Fed easing off on stimulus. US equity indices of the Dow and the S&P 500 touched record highs in May while bond yields have risen by 50bps from lows over the last one year. Money is moving from safe haven bonds to risk assets leading to a divergence of trends in equities and bonds.

India has seen both equities and bond rallying over the last one year with the Sensex and Nifty up over 15% and bond yields down by 125bps over the last one year. Indian markets have cheered easing inflation that is down from 9% and above levels to 5% and below levels and have cheered RBI rate cuts with repo rate being cut by 125bps since April 2012.

The outlook for the US economy is positive given incoming data of falling unemployment rates, monthly job additions, rising home prices and strong consumer confidence. US Bond yields are vulnerable to shifts in the economy given that yields are still seen as low at just 2.1% on the ten year treasury. The Indian economy on the other hand is going through a rough phase with growth slowing down to decade lows. Interest rates will have to come off in the economy for growth to stabilize and rise.

The arbitrage for FIIs is the rising yield curve prospects in the US and falling yield curve prospects in India. FIIs will invest in INR bonds to take advantage of this fundamental arbitrage.