Bearish bond market signals

So far, Indian equity investors have ignored this. But there could be some impact with a lag

Since January 2018, foreign portfolio investors (FPIs) have invested a net ~85 billion in rupee equity and sold a net ~108 billion in rupee debt. In April, which was the start of a new fiscal year, they sold ~55 billion of equity and ~100 billion of debt.

The April numbers have skewed the data downwards. Between January and March 2018, the FPI attitude was net positive with net equity buying of ~139 billion and net debt sales of ~8 billion. The Nifty was up over 6 per cent in April despite the FPI sales. Domestic institutions bought ~86.6 billion in April, and retail investors were also net buyers.

But if FPIs maintain a consistently bearish attitude, it will eventually drag the market down. The reasons why they might have turned bearish have more to do with the bond market and macroeconomic considerations than corporate earnings.

Many companies have posted good profit growth in Q4. However, the rupee has weakened and is now testing support between 66.50- 67 per dollar. That impacts FPI returns. The currency depreciation means the dollar index return is negative in calendar 2018.

The attitude to rupee debt indicates that FPIs think interest rates are headed up. There are restrictions on FPI purchases of debt. There are caps on ownership of government securities and corporate bonds for FPIs. There are also caps on ownership of government bonds in terms of tenure to maturity. Although the limits have been increased recently, they are very low, compared to other Emerging Markets. In prior periods, however, FPIs have hit limits. They have been sellers, so far, in this fiscal.

Bond market players hope for a trend of lower interest rates and lower yields. That means capital gains, while higher yields mean capital loss. But the Indian bond market has seen higher yields since mid-2017, despite stable policy rates.

Higher yields have pulled down returns. Long-term debt funds have a return of 3.4 per cent in the last 12 months versus double-digit gains in the two previous years and a long-term compounded annual growth rate (CAGR) of 7 per cent. Due to the limits, the bulk of FPI investments are in long-term securities with residual maturity of above three years. This is the category at most risk if rates rise. When currency risk is factored in, that's a double whammy.

The benchmark 10- year GSec yield has moved from 6.9 per cent in May 2017 to 7.75 per cent now. It hit lows of 6.44 per cent in July 2017, and highs of 7.8 per cent in March. The uptrend has been quite steady since August 2017.

Post-budget, yields hardened as investors absorbed the implications of a higher fiscal deficit and rise in government borrowing. Then the government ‘talked’ yields down by stating it would curtail first-half borrowing, claiming it would borrow only 47 per cent of 2018-19 needs. It normally borrows over 60 percent in the first half. Yields falling in March from 7.7 per cent to 7.2 perc ent also meant high capital gains for long-term debt funds. This was a brief but welcome rally. FPIs booked profits by selling ~90 billion as yields fell.

But yields have risen again through April. First, it doesn't seem credible that the government can curtail borrowing to the claimed extent. Second, the minutes of the Reserve Bank of India's Monetary Policy Committee reveal a willingness to hike. A rate hike would trigger some selling in equities.

Meanwhile, the yield on the US 10-year treasury bill spiked above 3 per cent for the first time in many years. Inflation could break above the Fed's targeted 2 per cent level. The Fed has signalled an intention to hike US policy rates, though it held rates steady last week. The European Central Bank and the Bank of Japan may also tighten policy soon. If policy tightens across dollar, Euro, and yen, FPIs may pull out of high-risk emergingmarket assets.

Indian Investors should be braced for this. It could mean more sell-offs in rupee debt, and in large caps, where FPIs hold big stakes. The safest debt fund options in this scenario are liquid and short-term funds. Accrual funds are safe, but the yield is locked in, without much chance of capital gains or loss. Thus far, domestic equity investors have ignored bearish bond market signals. But the equity market always lags the debt market, and a correction could be around the corner.