The movement of interest rates in the bond market is an effect of multiple factors, namely: inflation, twin deficits (fiscal and monetary), banking system liquidity, the central bank’s signals on interest rate movements and global factors including foreign portfolio investments in debt. Of these factors, investments by foreign institutional institutions (FIIs) in debt is relevant, but is of limited relevance. The factors that are of primary relevance are domestic factors like the ones discussed above and the action of domestic institutions in the market, i.e., the extent of their purchase or sale. It is important to bifurcate the impact of global influence on our bond market into two categories: (a) market sentiment due to global factors like crude oil price movement, central bank decisions, significant yield movements, and currency movement, and; (b) action of FIIs in debt in India.
Total investment of FIIs in government securities (G-secs) is only 3.2% of the outstanding stock. In corporate debt, the holding of FIIs is relatively higher at 7.5%. Their combined holding of central government and private sector bonds, by weighted average, is 4.6%. So, FII holding is less than 5% of the stock, which can influence the market to some extent, but with a limited magnitude. In some Asian economies, such as Indonesia, Malaysia, and the Philippines, FII holding is much higher.
Some recent events are fresh in memory: demonetization and the US election result in November. The bond markets in US and India went on distinctly divergent directions.
The US Treasury 10-year yield moved from 1.85% on 8 November to 2.4% now, after touching 2.6% in between. As price and yield move inversely, prices declined as yields moved up. India’s 10-year G-sec yield, which is the popular measure for interest rates in the G-secs market, rallied from 6.8% on 8 November to 6.38% now after touching 6.18% in between.
Reasons are not far to seek: the sudden demonetization announcement led to more liquidity in the banking system and consequent higher demand for government bonds, expectation of better direct tax collection for the government, lower inflation, and short-term impact on growth of gross domestic product (GDP) leading to the RBI’s action of easing interest rates. In the US, the bearish movement of yields moving up was led by the expectations of: better growth, higher deficits and higher inflation. A point to note here is that though FIIs sold in our debt market and the US yields went up, our market rallied as it is driven by fundamental factors and actions of the domestic market participants.
The rally in our market in this phase was driven primarily by participation of domestic institutions, on the out-turn of the demonetization event.
The global situation 3 years ago, in 2013, was that the US Federal Reserve was talking of ‘taper tantrum’: the US Fed was purchasing bonds from the market to keep interest rates low, which they were about to taper gradually. At the first hint of ‘taper’ in May 2013, yields started moving up globally. A similar impact happened in India also. India’s 10-year G-sec yield moved from 7.15% in May 2013 to 7.55% in mid-July 2013—a moderate 0.4%. In that period, movement in the US Treasury yields was similar. But thereafter, the bear rally that happened in India was primarily due to domestic developments.
The RBI increased signal interest rates and tightened liquidity, in a rate-driven defence of our currency, which was weakening in the wake of ‘taper tantrum’. The premise was, higher interest rates would induce FIIs to buy our bonds. The 10-year benchmark yield went from 7.55% in mid-July to as much as 9.23% in mid-August 2013. It was a significant upward movement of rates, meaning as much consequent decline in prices, driven by RBI tightening. This is another example of domestic factors taking precedence over FII action, in our bond market. Though FIIs primarily seek yield from Indian debt, as we have a reasonably good credit risk and offer attractive yields, they were in no mood to buy-in at that juncture, irrespective of the discount, due to ‘tapering’.
Apart from phases of extreme market movements discussed above, let us look at calendar year returns to form a perspective on the context. After the sell-off by FIIs in 2013, in 2014 they bought aggressively in debt—$26 billion. Our interest rates eased, and 10-year yield moved by 1% from 8.82% to 7.85% over the year. However, it was driven largely by expectations of monetary policy easing by the RBI, which finally commenced from January 2015. In that year, FIIs purchased a decent quantum of $7.5 billion in debt, but bond yields stayed stagnant as the outlook on future policy rate easing by the RBI was not certain. In 2016, FIIs sold $7 billion, but interest rates have rallied significantly, and the 10-year yield has eased by more than 1% over the year.
In sum, domestic market participants, who shape yield movement in the bond market, look at factors such as RBI signals, domestic data points and relevant global data points. The reason for limited impact of FII action in the bond market is limited exposure. The traded volume in our government securities market, which is Rs40,000-50,000 crore on a typical day to more than Rs1 lakh crore on a buoyant day, is adequate to absorb sales by FIIs. There are regulatory ceilings on FII investment in debt and it can be in securities with maturity of over 3 years. Investors in bonds or fixed income funds, while taking the decision on portfolio allocation, need to look primarily at domestic factors, global sentiment drivers and FII action in our market, in that order.
Joydeep Sen is an independent bond market analyst.