Debt's the way to go for FIIs

Foreign institutional investors (FIIs) are still betting on India, but not in equities. Debt has been the way to go for them.

Till October 14 this year, FIIs were net sellers in equities at Rs 1,132 crore (Rs 11.32 billion) while their debt exposure stood at Rs 20,029 crore (Rs 200.29 billion). This is the first time since 2008 that FIIs are net sellers in equities.

The going, of course, has been slow. After a blockbuster year in 2010, when they pumped in as much as Rs 179,674 crore (Rs 1796.74 billion) in equities and debt combined — the highest in a decade — this year they have made net investments of only Rs 18,897 crore (Rs 188.97 billion).

"For FIIs investing in debt, there is a margin of more than three per cent on a fully hedged, risk-free basis. Typically, foreign banks take advantage of this," says U R Bhat, managing director, Dalton Capital Advisors (India).

He says when interest rates are at a peak, FIIs want to invest in dated treasuries and book profits when rates fall.

The numbers do look very profitable. With the Libor (London Interbank Offered Rate) at 0.91 per cent, big foreign banks can borrow at Libor or Libor-plus 25 basis points. Their hedging cost through one-year forward contracts comes to another 3.5-4 per cent.

Even after incurring all these costs, they stand to make 3.5-4 per cent because 10-year government bonds are offering 8.76 per cent.

That implies capital gains of almost 100

per cent. If invested in corporate bonds, the returns are even higher.

AAA companies are offering around 10 per cent. And, the returns keep improving as the rating goes down and riskier paper is purchased.

In addition, with expectations that the rupee will strengthen to the 42-44 range versus the dollar in one year's time, any investor in debt would be sitting on a neat profit of 16-20 per cent.

Investment consultant Gul Tekchandani says FIIs have no reason to worry as things are likely to get better.

"If the Reserve Bank of India goes for another interest rate hike and then pauses, the returns would go up further."

If bond rates start falling, the yields will go up further, allowing investors to earn even more on their debt investments.

"Technical chartists are not taking the rupee depreciation into account when they are talking about market valuations.

For FIIs bringing in fresh dollars, the stock market is already cheaper by a good 10 per cent, with the Nifty at 4,500-4,600 levels," says Tekchandani.

According to him, the stock market has started seeing some attention lately because FIIs are realising there is huge profit to be made, even in the short term.

No wonder, in the last decade, FIIs have been net sellers (debt and equity combined) only once in 2008.

They have consistently been bullish on Indian equities. In 2010, they invested as much as Rs 133,266 in equities and Rs 46,408 crore (Rs 464.08 billion) in debt - the highest ever investment in a decade.