Foreign Investors Exit Indian Bonds as RBI Forex Curbs Spike Hedging Costs to 12-Year Highs

The Indian central bank's foreign exchange curbs prompted overseas investors to take profits in the South Asian country's government bond market, sparking a selling cycle that sent borrowing costs to a two-year high, a top fixed-income official at the Nuvama Group said on Tuesday.

India tightened rules for forex trading between late March and early April to support a rupee that fell to record lows as the Iran war pushed up oil prices, worsening the growth and inflation outlook for the net oil-importing country.

The FX measures, now partially reversed, helped the rupee but led to a surge in the cost of hedging rupee exposure overseas.

This "created an opportunity for already invested funds to unwind their hedges at a profit and exit bond holdings in India," said Ajay Marwaha, head of fixed income markets at Nuvama, a global wealth firm based in Mumbai that manages about $37 billion.

The rise in hedging costs offered a "windfall" to investors while deterring them from adding positions, Marwaha said.

Overseas investors pulled out 222 billion rupees ($2.37 billion) from Indian bonds between March 1 and April 15, sending the benchmark 10-year bond yield up by nearly half a percentage point to 7.15%. Bond yields move inversely to prices.

"The FX-triggered bond selling then led to rate-triggered selling by other foreign investors, followed by domestic asset managers and insurers who needed to cut their exposure to longer dated bonds," Marwaha said.

It would take a significant rise in bond yields or a change in the rates outlook for investors to come back to the market, Marwaha said.

Nuvama expects India's benchmark bond yield to move in a range of 6.95% to 7.05% over the next one month and in a 7.05%-to-7.15% range over three months, with risks of further rise if El Nino hits monsoon rains.

HIGHER BOND VOLATILITY

Bond purchases by foreign investors for margin funding needs are adding to debt market volatility, Marwaha said, with investors holding close to 70% of the equity trading margin in bonds and churning that portfolio.

Limited supply of short-term bonds after the central bank's hefty purchases last fiscal year is also pushing up yields, he said.

"All short-dated bonds are in short supply. A lot of them have been given away in OMOs (open market operations). Banks are now trying to short these papers and sell it to foreign investors."

The yield on India's 7.37% 2028 bond, which is listed on three global bond indexes, jumped 75 basis points from March to mid-April despite the central bank assuring it was not thinking about rate hikes. ($1 = 93.8313 Indian rupees)

(Reporting by Dharamraj Dhutia and Ira Dugal in Mumbai; Editing by Mrigank Dhaniwala)

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