It is a well-known fact that FIIs sold in excess of Rs.125,000 crore in equity and debt in the month of March. However, post-Mar-20, the flows into equity have been more or less positive. However, FIIs continue to sell in the debt market. In fact, in the Jan-Jul 2020 period, FIIs sold Rs.108,000 crore of debt in the Indian markets. What exactly is driving the aggressive selling by FIIs in the debt market? It is not about FII limits at all because FIIs have not used up even 50% of their available limits in G-SECs and in corporate bonds. There are 3 factors driving debt selling by FIIs.
All about negative real rates
The real rate of return is what investors earn on their investment after inflation is factored in. Till one year back, Indian bonds offered real bond yields above 4% making them very attractive by global standards. However, over the last 1 year, the bond yields have fallen to below 5.8% and the inflation has shot up closer to 8%. As a result, the real return on bonds has become negative. It is interesting when you compare the real rates of Indian debt with other countries. Other than Turkey, India has one of the lowest real returns on debt in the world. Even mature economies like Japan, EU region, and Australia are now offering real rates of returns that are better than India. As a result, most of the risk-off flows into debt are moving away from India into a developed market, which offers better real yields on the debt.
Sovereign rating a major issue
It may be recollected that Moody’s had recently downgraded India’s sovereign debt to Baa3 in Jun-20. This is the lowest rating in the investment-grade and any downgrade from here will push India into a speculative category alongside Russia and Nigeria. That would mean a sharp fall in bond prices and a spike in bond yields. Global investors fear that such a move would result in huge losses on their debt portfolio. But why are FII investors wary of another rating downgrade? Firstly, all 3 global rating agencies have kept India at the same rating level. Secondly, with fiscal deficit likely to cross 8% in FY21, most of these FIIs see a distinct possibility that India could see another downgrade.
There is the rupee issue too
FII returns on debt are also largely dependent on the currency as a 5% weakness in the rupee can almost wipe out bond returns. In the last one year, INR is down 8% making it one of the worst-performing EM currencies. There was also a major worry over the latest RBI Financial Stability Report, which hinted at the gross NPAs of Indian banks moving up from 8.5% to 12.5% by March 2021 if a worst-case scenario played out after the EMI moratorium was lifted. That could be a big setback for the Indian rupee. It is an amalgam of these factors that is keeping FIIs wary of investing in Indian debt.
