High yields on Indian paper continue to lure foreign institutional investors (FIIs) who have pumped in close to $6 billion into the country’s bond market in 2014 so far, driving up the rupee. The Indian rupee hit a seven-month high of 60.79 on Monday on the back of sustained inflows, primarily into the debt market.
“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