Is huge FII participation in Indian debt markets justified?
Over the last few months Foreign Institutional Investors (FIIs) have shown huge participation in Indian debt markets. FIIs, who were net sellers in debt markets in 2013, are currently net buyers in 2014 (YTD). Compared to net sell of Rs 50,848 crore in 2013, they bought a total of Rs 35,531 crore in 2014, in the Indian debt markets.
FII Participation in Indian Debt Markets
Source: ACE MF
However the huge participation over the past 3 months has not helped the yield to ease. The 10 year G-sec yield was at 8.80% levels at the end of December 2013. It has breached 9.1% level in the first week of April 2014. This shows that there has been no benefit for the debt market investors over the past 3 months.
So what has led FIIs to exude such confidence?
Primarily FIIs seem enthused by improving macroeconomic variables in India, such as:
Also, FIIs seemed to be attracted by the narrowing gap in yields (about 6.2%) between Indian and U.S. Government bonds. Likewise, high interest rates in India have encouraged them to show interest in the Indian debt markets.
So apart from the improving macroeconomic scenario, FIIs are also playing on the inflation and bond yield differentials. If the spreads persist going forward as well, it would bring in more FII flows in the Indian debt market.
But there are some worrisome factors...
What strategy debt market investors should adopt?
- Inflationary pressure: The unseasonal winter rainfall witnessed in some parts of the nation can be a risk to food inflation. The possibility of an El-Nino phenomenon this year is a further threat to inflation. It is noteworthy that the inflation has shown an ease in last couple of months.
- Fiscal Deficit: In the first 11 months of the fiscal year, the fiscal deficit has already exceeded to 114.3% of the full-year target. While the finance minister Mr P. Chidambaram has shown confidence of containing the fiscal deficit to 4.6% of GDP; in our view, it would be breached.
- Risk of sovereign rating downgrade: Global rating agencies like Moody's, S&P and Fitch have repeatedly threatened to lower India's credit rating. A downgrade would mean pushing the India's sovereign rating to junk. Moody's had cautioned that India's fiscal position remains weak. On the other hand, S&P has already said chances of credit ratings downgrade for India is high. It has indicated to downgrade India's sovereign rating if the new government does not appear capable of reversing India's low economic growth and put the house in order.
PersonalFN is of the view that, it would be best to refrain from investing in long term debt instruments. You can instead prefer short term instruments, as short term rates are still attractive. Moreover, the liquidity infusion steps taken by RBI will benefit short term funds. Going forward, mutual funds holding money market instruments like CD and CP in their portfolio may offer a better YTM (Yield to Maturity). Hence in the present scenario, it would be prudent to invest in short term debt mutual funds. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1month. Or liquid plus funds for next 3 to 6 months.
If permitted by your time horizon and risk appetite, you may take some exposure in long-term instruments via dynamic bond funds. Dynamic bond funds can hold debt instruments of various tenures. As a caution, you should not hold more than 20% of your debt portfolio in such longer tenure funds. FMPs can be considered as an option to bank FDs only if you are willing to hold it till maturity. Banks are offering interest in the range of 8.00% - 9.00% p.a. on 1 year FDs.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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