In the two months post the budget, the FPIs have been selling heavily into equities. However, they are still buying aggressively into bonds. What is the reason? The big story the last one year has been the aggressive flow of investments into Indian 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. Why is it that these FPIs appear to have fallen in love with Indian debt paper? It is already classified as the most attractive paper along the Indonesian bonds. Let us look at why these FPIs are allocating so Indian debt?

It is all about real interest rates, which is one of the highest in India

Where else in the world do you get 3-4% real rates of interest on an average? 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 6.58%. Considering that the average CPI inflation has been around 3%, it leaves you with a net return of nearly 3.58%. That is the kind of real interest rate scenario you cannot get anywhere in the world. The other related advantage is that gap that Indian yields enjoy over US bond yields, which is closer to 5% currently.

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.

With dovish rates, debt can still give capital appreciation

A lot of foreign investors are also buying Indian bonds after the 35 bps rate cut by the RBI and are now expecting another 40 bps in October. 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 3%, 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 “Neutral” to “Accommodative” in this year. That shift in stance has been major boost for bond prices. It is this boost in bond prices that most debt market investors are currently playing for

Don’t forget, FPIs look at currency as much as rates

This factor is more relevant for FPIs than for domestic 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, currently, the INR has depreciated from 68/$ to a level of 72/$. This appreciation has encouraged FIIs to further invest in the rupee bond as the RBI has been steadily supporting the rupee around the 72/$ mark. In fact, FIIs would ideally prefer a situation where the INR is either steady or calibrated versus the USD. They would be more comfortable with a calibrated weakening.

The deluge of flows that we have seen into debt in the last 2 months has been more pronounced post the budget 2019 in July. Even though growth is lower, the macros are sound enough to attract greater interest from FPIs into Indian debt.