With Fed signaling that it might end its stimulus program emerging market equities have been getting hammered. Plans to withdraw stimulus indicates that growth prospects in US have improved and the economy no longer requires external support. This led Foreign Institutional Investors (FIIs) to sell their emerging market high risk holdings and move towards domestic equities.
However, it may be noted that this exercise was not just limited to equities. FIIs were also seen selling their Indian bond holdings. In addition, the huge appreciation of dollar in the past week meant that their dollar return on rupee denominated bonds was negatively impacted. This further triggered selling of their rupee bond portfolios.
In fact, as per an article in First Post, FIIs have sold US$2 bn worth of bonds in the last fortnight alone. This has led to rising bond yields. Selling pressure reduces bond prices and thus increases yields. Basket selling has also led to further depreciation in the rupee.
But now the question is will this exercise continue or end?
For that first let us understand why FIIs invest in Indian bond markets. The reason is simple. They can exploit interest arbitrage by investing in Indian bond markets. The bond yields in India are in the region of 7-8%. The same in developed world is in the region of 2-3%. Hence, by investing in India they can get a yield advantage of 4-5%. However, this arbitrage does not take into account the currency risks. Nonetheless, if currency risks are hedged the advantage may go down but it will still remain and not go away completely..
The second reason why foreign institutions get attracted to Indian bond markets is they need to hedge their fixed income liabilities. For instance, let us assume a pension fund in US needs to fund its pension liabilities of the future. If the fund invests in US markets it will get only 2-3% yield on its invested assets. However, investing the same money in Indian bonds will yield the fund 7-8%. Thus, investing in Indian bonds would mean that the fund is better placed to meet its liability payments. It may be noted that pension fund will prefer to invest into safe assets like government bonds so that it does not risk liability payments into the future. Thus, bond investments are more likely for such funds rather than stock investments. And with bond yields in India being higher they will continue to attract foreign funds.
Thus, we feel that the current outflow of foreign funds from the Indian bond markets is temporary in nature. It has got more to do with the dollar appreciation which is hurting the rupee investments of FIIs. For instance, the dollar has appreciated by 7-8% over the last fortnight or so. This effectively means that the entire yield advantage of 4-5% has been wiped off. In addition, to that foreign investors have effectively incurred exchange loss on their investments. Fearing further currency losses they might have exited from the market. But once the currency volatility dies down they are bound to return to the Indian market.