After four consecutive years of inflows, foreign portfolio investors (FPIs) have pulled out ₹8,089 crore from the debt VRR segment amid lack of opportunities to invest in stressed or structured credit, dearth of auctions and the end in withholding tax benefit.

This is in stark contrast to the inflows of over ₹80,000 crore in the Indian debt market (after excluding the VRR segment), a large chunk of which could be front-loaded flows ahead of India’s inclusion in global bond indices later this year.

VRR, or voluntary retention route, was introduced in March 2019 with the aim of attracting long-term overseas money into the debt market. Investments through this route are free from macro-prudential and other regulatory norms that apply to regular FPI investments.

“There aren’t too many deployment opportunities available right now, especially in the distressed space, as pockets of stress in the corporate world have been cleared out,” said Ajay Manglunia, MD & Head, Investment Grade Group, JM Financial.

There were a lot of opportunities offered by promoter financing 2-3 years back, which is not the case right now, according to Manglunia. Promoter leverage has reduced significantly because of which the high yields are not available. Besides, there has been a dearth of VRR auctions in the past few months, which are needed to acquire the VRR limit by new investors, he said.

Investors with a three-year investment horizon have begun moving out given the end of the 5 per cent concessional tax rate last year. The effective withholding tax on rupee-denominated bonds now stands at 20 per cent.

“The outflows highlight the impact of tax policy changes on investor sentiment, emphasising the importance of a balanced fiscal approach to maintain market competitiveness,” said Suresh Swamy, Partner, Price Waterhouse & Co.

hedging costs

After accounting for currency hedging costs of around 4 per cent, it would be better for FPIs to stay invested in developed markets such as the US where yields have inched up significantly across maturities, according to Manglunia.

Let us say an FPI invests into a 1,000-rupee bond with a coupon rate of 10 per cent per annum. If ₹100 is the interest received, the 5 per cent withholding tax reduces the income to ₹95. Deducting the hedging cost of, say, 4 per cent per annum on the principal, the FPI gets back ₹55. If the tax deducted increases to 20 per cent, this income reduces to ₹40, which is lower by 27 per cent.

“The selloff could be taken as a part of the re-alignment of the portfolio near to or at the end of the minimum retention period. It is also partly driven by the rise in yields of US securities and expectations of further rupee depreciation against the dollar. This sentiment, however, could change going forward,” said Yashesh Ashar, Partner, Illume Advisory.

VRR investment is subject to the investors voluntarily committing to retain at least 75 per cent of their total investments for a period of three years.

The investment limit under this segment was has been raised to ₹2.5 lakh from from ₹75,000 crore earlier.