The high local yields and expectations of a stable currency are responsible for the sustained debt inflows this year, said Brijen Puri, head of trading at JPMorgan Chase.
A sharp rise in short-term rates had prompted foreign investors to buy treasury bills and commercial paper; of the $5.8 billion in FII flows that have come in, $4 billion has flowed into short-term paper.
Three-month treasury bills offer a yield of 9.20% while commercial papers are priced even more attractively at 10.0-10.25%. However, with investment limits in short-term paper having been breached at the end of February, FIIs appear to have turned their attention to the most liquid long-term bonds.
In the first five sessions of March, FIIs have invested $1.24 billion in Indian bonds.
Typically, an FII borrows through a dollar loan overseas, the cost of a one-year loan being around 1%. The investor then brings in the borrowed dollars to buy rupee bonds from the domestic market.
Most FIIs hedge the currency risk in the offshore non-deliverable forward (NDF) market where the three-month premium for dollar/rupee are at levels of 7.0-7.5%. Given that three-month treasury bills currently offer a yield of 9.20% yield, foreign investors are able to make a clean 2% spread on the investments. In the case of commercial paper, the spread is even larger at 3%.
Forward premia across short-term tenures have trended down. Irrespective of whether the FII hedges onshore or offshore, the investor can still make a spread of 1.5%, said Jayesh Mehta, head of treasury at Bank of America-Merrill Lynch.
Mehta said that long-term bonds in the five-year and six-year segment offer similar yields and that bonds such as the 8.12%, 2020 and the 7.28%, 2019 seem to be preferred by FIIs since they are highly liquidity. The most liquid 10-year benchmark 8.83%, 2023 bond has been trading at a yield of around 8.80%.
Some market watchers believe chances of making a high return on a fully hedged basis are now slowly lessening. Manoj Rane, head of fixed income and treasury at BNP Paribas, pointed out that if one borrows to invest and hedges the forex risk, you could have a negative carry right now.
Bankers, however, say the rationale to invest in long-term government bonds also stems from the differential between yields on Indian bonds and those on paper from other emerging markets. Bond yields in other Asian markets such as South Korea, Taiwan and Indonesia are in the 1.0-3.0% band. Indian bond yields across tenures are 8.50-9.50%, which could prompt FIIs to allocate more funds to Indian debt.
The flows could be also be due to allocation. We saw nearly $20 billion go out last year. If $4-5 billion of that has come in, it is not a big event, Rane said.