The finance ministry hiked the FII investment ceilings in government and corporate bonds by $5 billion each. FIIs can now invest up to $15 billion in government bonds and $20 billion in listed corporate bonds. The measure will help the government push through its bloated borrowing plan and hopefully lower interest costs.
Yields on the 10-year government benchmark bond fell 7 basis points to 8.81%, after hovering close to 9% for several days. Rising yields have forced the government to give higher coupons on new bonds, even as the RBI struggled to sell debt paper in a recent auctions.
For instance, the government recently offered a return of 8.79% on a new 10-year bond against the 7.8% it gave on a similar maturity bond some months ago, indicating a rise in borrowing costs of roughly 100 bps.
Thomas Mathew, joint secretary, capital markets, ministry of finance, said the measures should result in increased foreign participation in the Indian financial market.
Though bankers said the move will help cool yields, investors did not seem enthusiastic enough. Oriental Bank of Commerce CMD Nagesh Pydah said higher FII participation should result in lower yields and bring down the governments borrowing cost.
Some industry experts, however, said currency and interest rate risk may dissuade FIIs from buying more bonds.
We can expect some increase in FII flows into debt. But unless there is a good hedge for interest rate risk, inflows will only be moderate, especially since most FIIs trade in bonds and are unlikely to hold these until maturity, said GV Nageswara Rao, MD & CEO IDBI Federal Life Insurance. Besides banks, mutual funds and insurance companies are the largest buyers of government bonds.
Higher FII participation could help arrest a falling currency. But the moot question is whether the foreign money will come or not, said the head of a large mutual fund who did not wish to be quoted. These measures should be combined with big policy moves like FDI in retail to win back the confidence of foreign investors, he added.
Yield on the 10-year government bond has risen 96 basis points this year, the most in Asia, as inflation remains untamed above 9% for the 11th consecutive month. The central bank has increased interest rates 13 times since last March to combat inflation.
FIIs, which stayed away from Indian equities this year, have raised their bond portfolio.
With interest rates peaking, these FIIs are hoping to benefit from appreciation in bond prices going forward as slowing growth may force the RBI to cut rates in the medium term.
FIIs have invested Rs 41,253 crore as of October 31, 2011 in government debt out of their existing quota of Rs 43,650 crore ($10 billion).
They bought Rs 68,289 crore of corporate bonds as on October 31, 2011, as against the ceiling of Rs 74,416 crore ($15 billion).