FIIs focus on government debt market

On 31 January 2008, the Securities and Exchange Board of India (Sebi) increased the investment limit by foreign institutional investors (FIIs) or their sub-accounts in government securities (T-bills) to US$ 3.2 billion from US$ 2.6 billion.

The investment by FIIs in debt-oriented mutual funds (including the units of money market and liquid funds) will be hereafter considered as corporate debt investments and reckoned within the stipulated limit of $1.5 billion, which is earmarked for FII investments in corporate debt.

The capital market regulator has cancelled the individual limits on investment in debt allocated to FIIs.

In less than a week after the Sebi raised the limit for FII investment in government bonds, foreign institutional investors (FIIs) are now knocking on the doors of the markets regulator asking for a hike in their individual limits.

Yields in the government bond market have been on the rise in recent times. The interest rate differential is best computed between the 90-day secondary market rate on government bonds in the US and in India. On January 31, the 90-day rate in the US was 1.92%. The Indian 90-day rate is roughly 7.27%, yielding a massive differential of 5.35%. This, coupled with the rising rupee and lower borrowing rates in overseas markets, makes it lucrative for overseas investors to look at the gilt market.

SEBI has already been flooded with applications from FIIs, intending to invest in the gilt market on an incremental basis. There have been significant amounts of outflows due to the fact that SEBI has categorised all investments in liquid mutual funds as corporate debt investments.

Once approvals from SEBI come through, investments by FIIs in government bonds will see a huge spurt. In fact, the rise in investments could be so sharp, that it could even bring down the yields from their current levels. FIIs who ended up bidding aggressively for the Reliance Power public offer will now find the surplus bid amounts finding their way back to them, in the post-allotment phase.

Market sources said that these funds, which were initially channelised into the stock market, may now find an entry into the debt market rather than getting reinvested in forthcoming public offerings. Demand from overseas funds, subscribing to the IPO, totalled $100 billion. The public offer was oversubscribed by 73.04 times.

Typically, FIIs invest in government securities of a shorter tenure, when there is an uncertainty about where rates may head towards in the medium to longer run. These include bonds under the market stabilisation programme or treasury bills.

Bonds are likely to be in ample supply for the last quarter of the financial year, with an upsurge in issuances under the market stabilisation scheme (MSS). Bonds, which are issued under the MSS route, are mostly of a shorter tenure, too.

Now, the Reserve Bank of India (RBI) has been aggressively intervening in the foreign exchange market to curb the rupee from rising against the dollar. In this process, it does infuse rupee funds into the system, as it mops up surplus dollars flowing into the country. In order to absorb the rupee funds back, RBI sells bonds through the MSS route.

On the other hand, the corporate bond market has seen fresh issuances drying up substantially January 2008, and to some extent, even this month. Issuers were wary of coming out with bond issuances in January since most of them were anticipating that RBI would lower rates in its quarterly policy review. However, rates were left unchanged and the pipeline for corporate bond issues is still extremely thin.

This leaves very less room for foreign investors to look for investment options in the corporate bond segment, and in turn, makes gilts a more viable proposition. As of December 2007, the outstanding FII investment in government securities and treasury bills through the normal route was $326.64 million. The outstanding investment in corporate debt securities was $ 480.83 million.

FIIs have two routes to enter India. One is the 70:30 route for equity, for FIIs, who can invest a maximum 30% of the money in debt here. The second is the route for pure debt FIIs, where the foreign investor has to register with Sebi as an FII.