FIIs have bought close to USD 3.5 billion of INR Bonds in the months of December 2013 and January 2014. FIIs have turned buyers after continuously selling INR Bonds worth over USD 10 billion in the June 2013 to November 2013 period.
Why have FIIs started to buy INR Bonds? Is there interest rate arbitrage available on a fully hedged basis? Are FIIs turning positive on the INR to run unhedged bond positions? Or are they turning bullish on INR bond yields?
On the arbitrage front, despite healthy differentials between yields on US treasuries and INR Bonds, the forward rates are too high for any spread plays. One and ten year US treasury yields at levels of 0.1% and 2.85% are way below INR bond yields at 8.7% and 8.65% levels respectively. The yield differentials work out to 8.6% and 5.80% respectively.
The borrowing cost for an FII would be around Libor plus 100bps to 150bps. Six months Libor is at levels of 0.33% while one year Libor is at levels of 0.57%. Assuming that an FII borrows six month Libor at 0.33%, the total borrowing cost at the lower end of spread of 100bps is 1.33%.
Six month forward rates for the USD/INR is 8.3%. The total cost for an FII on a fully hedged basis is 8.3% + 1.33% = 9.63%. Hence the FII is actually earning a negative spread by investing in one or even ten year INR bonds. Corporate bonds too do not offer spreads for the FII as one, three, five and ten year AAA corporate bonds are all trading at levels of 9.35% to 9.6%.
FIIs are not buying INR Bonds for interest rate arbitrage, as there are not any available. So why are they buying INR Bonds?
FIIs are tending to believe that the INR is fairly valued at current levels of Rs 62 to the USD and has scope for appreciation going forward. The reason for this is that many macro factors that took down the value of the INR by 12% in calendar year 2013 is turning around. Current Account Deficit is down 40%, fiscal deficit at 4.65% of GDP (expected) for fiscal 2013-14 is down from last fiscal levels of 4.8% of GDP. Inflation at the consumer and wholesale levels are seen to have peaked at levels of 11.2% and 7.5% as vegetable prices that drove inflation to higher levels are falling sharply. Economic growth forecast is positive with IMF revising upwards the growth forecast for the country.
Political risk in the form of a hung parliament is ever present given elections in May 2014 but that is not deterring better macro conditions. The Fed tapering is not seen as too negative this time around given that markets have adjusted positions accordingly. Markets had sold off emerging market currencies and bonds in the June 2013- September 2013 period on tapering fears.
FIIs are buying INR Bonds largely on an unhedged basis though they will periodically play the INR movements in the NDF (Non Deliverable Forwards) market.
FIIs are also turning positive on INR Bond yields that have come off by almost 30bps in the month of January 2014. Ten year benchmark government bond yields are down from levels of 8.90% to 8.60% on the back of the markets taking out bets of rate hikes by the RBI and on the back of the government lowering its borrowing by Rs 150 billion for fiscal 2013-14. RBI is likely to keep liquidity comfortable in the system as economic growth at below 5% levels is well below trend growth levels of over 7%.
FIIs are likely to continue buying INR Bonds given better domestic and global macro prospects but bouts of selling are not ruled out if either domestic politics or prospects of rate hikes in global economies gain ground.
