In a regulatory fiat that stunned the debt market, Sebi has slapped a $500-m cap on FII investments in corporate bonds.

With the market having built a position of close to $1bn, the move has caught some banks on the wrong foot and is expected to trigger a sell off in corporate bonds.

"Foreign funds have been mostly buying short-term papers and the government is not too comfortable with this. Besides, this could be a step to lower the dollar inflow," said a senior banker.

The decision, somewhat arbitrary, comes two days after the government had said that corporate bonds will be excluded from the $1.75-bn limit set for FII investments in all forms of Indian bonds - government securities, treasury bills and corporate debt.

Having taken this as a hint that there will be no investment cap on corporate bonds, FIIs and banks representing them went on a rampage this week and bought around $1bn worth of corporate bonds.

A few foreign banks also built up positions with the hope of making a killing by selling it to their FII clients. These banks may have to take a hit.

Soon after the announcement, several institutions like NHB, IDFC, Exim Bank, HDFC and Nabard, among others, floated bonds which were subscribed by banks and to an extent by mutual funds. Transactions worth $1bn took place. Dealers said they had not seen such a quantum hitting the primary market in such a short time.
FIIs will now have to stick to a cap of $500m on corporate bonds, even though it will be over and above the $1.75-bn ceiling for G-secs set earlier. While volumes fell due to the new cap, yields in the secondary market continued to fall.

The $500-m cap applies to cumulative FII investments in corporate paper in India. Of the $1bn worth of corporate paper, FIIs have already bought around $200-300m.

In addition to this, they have contracted or given buy orders for another Rs 3,000-4,000 crore to banks and primary dealers. The $500-m cap is likely to hit banks and few primary dealers (PDs) also who may have bought these bonds on behalf of FIIs and are now stuck with these securities.

The past few days have seen a sharp spurt in commercial paper and one-year bond issuances by domestic corporates.

FIIs normally purchase shorter tenure papers specially of triple A corporates. Purchases of short-term papers helps the FIIs, as they will not have to then pay withholding tax which would affect their overall returns.

Sebi needs to now decide on what criterion it will sanction limits to FIIs for buying local debt. Bankers feel this could either be on pro-rata or on a first come, first serve basis.

"Whatever be the outcome, many banks will now have to suffer a loss. The regulatory authorities should have issued a clarification on Monday evening. This sends out a wrong signal to the market and also the international community," said a senior banker.

Some of the US-based banks are said to be affected by Sebi's move. The FIIs of Barclays, Citi and JP Morgan are believed to have been very bullish on the debt market.