Hike in FII investment limits in corporate debt will aid the growth of bond markets: ICRA

At USD 10.11 billion during Q1FY2018, inflows from foreign institutional investors (FIIs) to the debt market were the highest in any quarter during the last decade.

The inflows were strong in G-Secs and corporate bonds even as the FIIs interest in state development loans (SDLs) remained subdued. The surge in inflows is likely to have been supported by lower inflation levels, stable currency levels and increasing expectations of a rate cut in the forthcoming monetary policy, apart from the less hawkish outlook for a rate hike, of the United State Federal Reserve.

With the surge in flows, aggregate FII debt holdings in G-Secs increased to record highs of Rs. 2.12 trillion as on June 30, 2017 which is considerably higher than the previous high of Rs. 1.8 trillion as on September 30, 2016.

The utilisation levels of available G-Sec limits for FIIs increased to 91.9 percent as on June 30, 2017; this was despite the quarterly increase being affected by the Reserve Bank of India (RBI) in the G-Secs limits to reach five percent of G-secs outstanding by March 31, 2018. FII holdings and utilisation levels in corporate debt also increased to record highs of Rs. 2.16 trillion and 88.6 percent respectively as on June 30, 2017.

The FIIs investment limit on corporate bonds remains unchanged at Rs 2.44 trillion during last 4 years. Though the FIIs investments in SDL increased marginally to Rs 17.0 as on June 30 2017 from Rs 15.6 billion as on March 31, 2017, however upon the increase in investment limits to Rs 270 billion for Q1FY2018 from Rs 210 billion for Q4FY2017, the limit utilisation declined to 6.3 percent as on June 30, 2018 from 7.4 percent as on March 31, 2017.

"FII's investment limits in corporate bonds remained unchanged at Rs 2.44 trillion since June 2013, while the volume of corporate bonds outstanding increased at a 22 percent CAGR during this period from Rs. 13.5 trillion as on June 30, 2013 to Rs. 24.81 trillion as on June 30, 2017. As a result, the FII limits as percentage of corporate bonds outstanding have effectively reduced to 9.8 percent from 18.0 percent. While a number of steps have already been taken by the Government and the regulators to deepen the corporate bond markets, a hike in the FII investment limit in corporate bonds would further aid the cause," said group head - financial sector ratings, ICRA Limited, Karthik Srinivasan.

As of July 24, 2017, the utilisation of FII limits in corporate bonds increased further to 97 percent, reflecting a need for an immediate increase in the limits. ICRA notes that maintaining the limit at the current level may not only impact FII inflows into the debt segment but may also reduce the volume of fresh corporate bond issuances to FIIs in the near-term.

"The prospects of non-availability of investment limits and the opportunity of potential capital gains on debt investments given the forthcoming rate cut could also have triggered the surge in FII debt flows during FY2018 (YTD). The surge in flows could also have attracted some short-term investors into the debt segment. Given our expectations of hardening of yields on debt securities in H2FY2018 and the current high utilisation levels, we expect the FII flows into debt to reverse in H2FY2018, which could lead to some volatility in yields. However, we do not expect the FII investment limits to act as barriers for overall fresh issuances and growth of corporate bond markets as the strong inflows into key investor segments namely Insurance and Mutual Funds and the surplus liquidity in the banking system will offer adequate opportunities to both issuers and investors," added Karthik.

With the increase in debt utilisation limits, the scope for further FII inflows into G-Secs and corporate debt remains limited to USD 5.4 billion and USD 4.3 billion for the balance period of Q2-Q4 of FY2018. While the macro-economic factors continue to remain strong, which will support the INR against steep depreciation, rising interest rates in the advanced economies and limited space in FII investment limits, may act as constraints for further capital flows into the debt market.

Notwithstanding the robust FII debt inflows in Q1FY2018, unless the FII investment limits are increased, the current high utilisation levels of these limits and possibility of profit booking opportunities may restrict the net annual FII debt flows to within our earlier estimates of USD 5-10 billion for FY2018.