Narrow India, US bond yield spread may cap FPI investment in Indian bonds

The spread between Indian and US bonds was at 177 basis points (bps) on May 15, compared to 221 bps on February 6, before the rate cut cycle in India

Even as the Securities and Exchange Board of India (SEBI) proposed easing regulatory compliances for foreign portfolio investors (FPIs) in a note on May 14, the narrowing of the spread between Indian and US bond yields could limit investment by these entities in domestic bonds in the short run.

Experts said that FPIs’ investment decision is guided by fundamental macroeconomic factors and the proposed easing of norms will not lead to an immediate surge in demand.

Usually, when the spread between two government bonds—or the gap between the yields in the bonds issued by the two countries—narrows, foreign investors pull back their funds from emerging economies and park it in home countries. This is because when the differential is lower, foreign investors end up earning lower returns as it gets adjusted with the currency exchange rate and other expenses related to compliance.

The spread between Indian and US bonds was at 177 basis points (bps) on May 15, compared to 221 bps on February 6, before the rate cut cycle in India. The spread between India and US narrows when the yield on one country’s bonds remains at elevated levels and that of the other sees a reduction. The spread started narrowing after the two consecutive rate cuts of 25 bps by the Reserve Bank of India (RBI).

FPIs investment in Indian bonds under the fully accessible route (FAR) has moved in a narrow band since the start of rate RBI’s cut cycle because these entities moved funds at a very slow pace due to the narrowing yield.

FPI investment in government securities (G-Secs) under FAR moved in a small range of Rs 2.74 lakh crore to Rs 2.95 lakh crore between February and April. On a few occasions, investments touched just over Rs 3 lakh crore.

“The reduced investment is not due to weak fundamentals but rather a temporary withdrawal driven by the exceptionally lower spread,” said Mataprasad Pandey, vice-president, Arete Capital Service.

Further, foreign investors refrain from putting money in Indian bonds when currency volatility is higher, which was the case during the tensions between India and Pakistan, when these entities pulled out money. As per data of Clearing Corporation of India (CCIL), foreign investors’ investment in G-Secs reduced to Rs 2.94 lakh crore as on May 15, from Rs 2.97 lakh crore on May 6, when Indian armed forces launched 'Operation Sindoor' in Pakistan and Pakistan-occupied Kashmir.

On May 14, SEBI issued a consultation paper on a proposal to facilitate relaxation in regulatory compliances for FPI applicants investing only in Indian government bonds.

The market regulator has proposed rationalising KYC or know your customer norm periodicity, timelines for disclosure of material changes, transition between regular FPI and IGB-FPI or Indian Government Bond-Foreign Portfolio Investors, among others. The regulator has invited comments from the public and market participants by June 3.