Everyone is talking about foreign institutional investors’ fancy for Indian stocks, but little about their flirting with Indian bonds.

FIIs have poured $7.7 billion into domestic bonds since January. This is 95 per cent of the money they pumped into equities and almost as much as they pulled out last year.

Why the sudden rush for Indian bonds?

According to experts, the still-high interest rates, the stable currency and the improving macro indicators make bonds attractive to foreign investors.

Ten-year government bonds offer a yield of 8.5 per cent compared with 7.9 per cent from similar instruments in Indonesia, 3.7 per cent in Thailand and 8.2 per cent in South Africa. In contrast, ten-year gilts in the US pay 2.6 per cent interest.

Three kinds of FIIs invest in Indian bonds, explains Santosh Kamath, CIO - Fixed Income, at Franklin Templeton Investments. One set that is attracted by the arbitrage offered by Indian bonds, after factoring in the forward cover.

The second that takes a medium-term view on the currency or rates. And, then, pension funds and other long-term investors which simply buy and hold long-term Indian government securities.

“The India story has changed dramatically. With the government expected to take further steps to develop bond markets, India is now seen as an attractive destination for foreign investors. This advantage is likely to stay even at lower yield differentials, provided the macro-economic improvement continues,” says Suyash Choudhary, Head - Fixed Income at IDFC Mutual Fund.

“Concerns about other emerging markets have led to a diversion of funds into India. Both country as well as currency risks have receded,” says Abheek Barua, Chief Economist, HDFC Bank.

Steadying rupee

FIIs are also ready to bet on Indian bonds today because they are more confident of the rupee’s direction and can hedge their exposure at a lower cost.

The rupee, which took a free fall in August last year to a low of 68.8 to a dollar, has since rebounded to 59 levels.

The current account deficit (CAD), which was at a precariously high $21.8 billion in the June 2013 quarter, has since receded to $4.1 billion by the December quarter of 2013. Forex reserves, which declined to $275 billion in August last year, are now at $313 billion.

“Stability of currency has been a great comfort to FIIs investing in our bond markets. FCNR inflows, and the RBI shifting its anchor for monetary policy to the higher CPI inflation, have contributed to this comfort,” says Choudhary. But what does the voracious FII appetite for Indian bonds mean to domestic investors?

Some portfolio managers argue that this will set off a bull run in bonds and pressure interest rates. As FIIs buy more bonds, their prices will rise and yields will fall.

But Kamath of Franklin Templeton thinks that this may be only temporary. “As there is a lot of positive sentiment and foreign money comes in, there is an opportunity for short-term rates to come down. But if the economy really picks up and the inflation scare starts, then there may be an upward pressure on rates. So, you should not take a one-sided view that rates can only go down. To put it simply, I don’t think there is a sustainable bull market in gilts.”

(With inputs from Aarati Krishnan)

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