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Why have institutional investors fallen in love with Indian debt?

Investment | Published on Sep 04th 2017 | Comment(s) 0
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The big story in the last one year has been the aggressive flow of investments into Indian equities and debt. In fact, the sub-narrative is a lot more important. While equity has been more or less neutral considering the valuations, it is debt that has actually attracted the lion’s share of the inflows. We are referring to inflows from domestic institutions and from foreign portfolio investors. In both the cases, the preference for debt over equity has been quite decisive. First let us take a look at the chart below to understand the monthly flows into Indian debt in the last one year…

As the above chart clearly highlights, FIIs infused $10.5 billion into debt in the last one year even as the domestic mutual funds infused a massive $54.27 billion into debt. In case of FIIs, the inflow into debt was a little under twice the flow into equity whereas in case of mutual funds the inflow into debt was nearly 4 times the inflow into equity. The moral of the story seems to be that there is a tremendous appetite for Indian debt paper. So what exactly explains this appetite? There are 3 broad reasons for the same…

Real interest rates in India are among the best in the world…

Real interest rates are the rates of interest that you earn net of inflation. That is where Indian debt appears to be scoring. Let us take the case of the most blue-chip debt which is the 10-year Sovereign G-Sec in India. The yield is hovering around the range of 6.54%. Considering that the average CPI inflation in the last 3 months has been around 2%, which leaves you with a net return of nearly 4.54%. Believe me, that is the kind of real interest rate scenario you cannot get anywhere in the world. At least, if you look at like-sized economies with GDP over $2 trillion, then it is unlikely that you will find another sovereign debt that pays such hefty real yields in excess of 4.5%. 

But then debt investors do not look at current real returns alone but also at expected real returns. That is again an area where Indian debt scores. With a good monsoon and a record Kharif output expected this year, inflation is unlikely to bounce back too sharply. Weak crude oil prices will also keep the pressure on inflation and push it downwards. On the yields side, the nominal yields on bonds may not really go down too sharply from here as the RBI has been very particular about sustaining its yield spread over the US benchmark to avoid any disruption due to risk-off flows. As the RBI credit policy document clearly showed, actual inflation in India has been consistently lower than the expected inflation over the last 1 year.

There is still room for capital gains on debt paper…

As we know, debt investors earn two kinds of returns. There is the interest yield on the debt paper that accrues to you. Additionally, the price of the bond goes up whenever interest rates are cut and yields go down. That will result in capital gains for the debt investors. That is what is attracting domestic mutual funds investors into Indian debt. With inflation staying around the average of 2%, the RBI will be induced to cut rates by 25-50 basis points before the end of the calendar year. That will give sufficient room for appreciation on these bonds. It may be recollected that the Monetary Policy Committee (MPC) had shifted its monetary stance from “Accommodative” to “Neutral” in April this year. However, the way inflation has panned out in the last few months, the MPC had cut rates by 25 bps in the August policy. It is expected that the first indicator may come when the MPC shifts its stance back to accommodative. That shift in stance itself could be a major boost for bond prices. It is this boost in bond prices that most debt market investors are currently playing for…

Finally, there is an interesting currency story favouring bonds…

This factor is more relevant for FIIs than for mutual funds since FIIs also have to look at the currency angle. A weakening currency means that a part of the returns on debt get neutralized by the rupee depreciation. On the other hand a strengthening rupee means that the currency gains are over and above the actual debt market gains for the FIIs. That is what has worked in favour of FIIs investing in debt. For example, since January 2017, the INR has appreciated from 68.5/$ to a level of 63.5/$. This appreciation of nearly 8% has helped FIIs to further boost their dollar returns. That is why, if you look at the FII inflow chart, the sharpest inflows have come in since the month of February onwards. In fact, FIIs would ideally prefer a situation where the INR is either steady or strengthening versus the USD. In a worst case, they would be comfortable with a calibrated rupee.

The deluge of flows that we have seen into debt in the last 1 year has been more pronounced since January 2017. With the current macros, the trend looks all set to continue!




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