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Business News/ Money / Calculators/  FIIs are buying bonds. Should you buy too?
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FIIs are buying bonds. Should you buy too?

Institutional investors have various mandates. Retail investors' should have own objectives

Indranil Mukherjee/AFPPremium
Indranil Mukherjee/AFP

Alot of interesting activity is taking place in the domestic bond market. On 20 August, foreign institutional investors were net buyers in the debt market to the tune of $2.65 billion (roughly 16,000 crore). This is a huge amount to buy in a single day, and resulted in the benchmark 10-year government security (G-sec) yield falling 0.6%. Given that the benchmark yields move on average 0.5%-0.10% in a day, this change is very noticeable.

Now let’s look at fund flows. The previous calendar year saw negative net flows from foreign institutional investors (FIIs) into the domestic debt market. However, this year so far, with net flows of around $16 billion or 1 trillion, it has beaten the equity market net inflows of around $12.5 billion.

As FII buying picks up, experts say that it’s not just short-term money that’s getting invested, rather there is medium- to long-term interest from FIIs that want to take advantage of a yield curve which is likely to trend lower in the months to come. While large participants in the debt markets, such as primary dealers, are following this development closely, do you as a debt fund investor need to take stock?

Every time there is a big inflow of FII money in the equity market, you wonder where they are investing and whether to follow suit or not? It is important for investors to be aware of the changing demand-supply dynamics in any market. But before acting on information, you need to analyse the impact.

Many shades of FIIs

Although the 10-year G-sec yield is the one that gets highlighted the most, it doesn’t mean that’s where everyone is investing. There are many different kinds of FIIs who invest in the Indian debt market for a variety of reasons. “There is one type of FII who just wants to play the arbitrage opportunity between forex one-year forward premium and the one-year yield. Then there is an FII that has a view on currency and interest rates, and this gets implemented by buying the most liquid government bond, which could be the 10-year G-sec. There could be third type of FII, like a sovereign fund, who would like the fundamentals of the country and are ready to hold for a longer term," said Santosh Kamath, managing director, local asset management-fixed income, Franklin Templeton Investments India.

So, there are different reasons for FIIs to invest in the Indian markets. As a result, there is demand across different kinds of bonds with different tenors.

FII investment in government bonds is dictated by limits prescribed by the Reserve Bank of India (RBI). In July, the central bank readjusted the debt investment limits for various types of foreign investors, allowing medium-term investors to invest an additional $5 billion while reducing by the same quantum the limits for long-term investors in government bonds.

So far, long-term foreign investors such as pension funds and insurance companies have utilized only around a fifth of their overall $10-billion (now reduced to $5 billion) limit.

Moreover, FIIs can incrementally invest in securities with residual maturity of three years and above for the additional $5 billion. This limit has already been exhausted. It shows that incrementally, FIIs are no longer just here for the short-term arbitrage but may be investing to take advantage of the potential turn in yield curve.

R. Sivakumar, head-fixed income and products, Axis Asset Management Co. Ltd, said, “There’s been a change in the very recent past, where we are seeing FIIs take a higher exposure in the 10-year G-sec."

According to Vikrant Mehta, fund manager–fixed income, PineBridge Investment Asset Management Co. (India) Pvt. Ltd, “FIIs are investing with different mandates and bring a different philosophy to the market than domestic funds or insurance companies. Today, if I am selling, there may be an FII willing to buy; it expands the market."

Essentially, FIIs coming in has put a set of two or three new investors in the market and these don’t behave in the same way as existing domestic institutional investors, which is good for the market.

The mutual fund investor

“At the moment, the FII exposure is not large enough to move the market in a big way or impact price discovery too much," said Sivakumar, adding that primary dealers and floor traders are more likely to feel the impact of this rather than fund managers.

This means that other than the daily volatility and creation of a kind of floor for yields thanks to the recent buying, there isn’t much impact on fund managers’ portfolio construction decisions. “Since we can’t time the FII buying, it doesn’t really make a difference to us when we look at portfolio building.," said Mehta.

For debt mutual funds, where incremental money gets invested, a lot depends on the supply in the market at the moment and the mandate of the fund itself. Schemes have different objectives—short-term income funds try to invest in securities with maturity of 1-3 years to match the medium-term needs of investors, while long-term income funds will have higher maturity securities to play out the interest rate opportunity. The latter are more likely to be affected by any yield volatility that heavy FII flows result in.

The same goes for equity funds; fund managers make choices based on fundamentals and the fund’s objective, rather than following FIIs.

What should you do?

Investing in debt funds is about creating income and that should be the principle dictating your fund choice. Whether you invest in money market funds, a short-term income fund or a fixed maturity plan will depend on your financial objective, time to achieve it and your risk tolerance. Nevertheless, you need to be aware of what’s moving yields in the market.

For the more informed investor who takes a view on the interest rate movement and wants to take advantage of duration, the FII investment trend plays a slightly larger role.

There is another point to be made. If FIIs are able to spot an opportunity in our debt market, what’s holding domestic investors back? So far this financial year, the income fund category has seen net outflows to the tune of around 8,500 crore.

The presence of a large class of investors that has the potential to invest large sums can eventually alter the dynamics of an asset market in a more material way. Till that happens, experts are optimistic about the steps being taken by the government and RBI to make the Indian bond market more robust and be in a better position to attract medium to long-term foreign investors.

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Published: 29 Aug 2014, 05:56 PM IST
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