Foreign funds are buying record levels of relatively high-yielding Indian short-term debt thanks to a strengthening rupee and reduced hedging costs, analysts said on Thursday.

The foreign funds have pumped $391.3 million into Indian debt this month, the highest monthly purchase since India allowed foreign funds to purchase local assets in 1993. It's also well above the $264.2 million total bought in the first four months of the year and just $3.9 million in the whole of 2002.

The buying is confined to short-term 91-day or 364-day treasury bills because foreign investors see lower credit risk in the shorter-term debt, strategists said. India's debt is rated as junk by credit rating agencies.

"The t-bills pose minimum risks to the investor concerned about India's rating," said an analyst in a foreign bank. "They have very short tenors so less worries. Right now they are chasing yields."

Strategists expect further buying as central banks worldwide consider possible rate cuts, widening the interest rate differentials.

"The 364-day t-bills offer an attractive return of 3.47 per cent on a fully hedged basis," said Siddharth Mathur, strategist at JP Morgan Chase.

Returns on a similar instrument in another emerging market such as Thailand would be 1.17 per cent while in the United States it would yield 1.24 per cent.

"This is an attractive proposition for foreign funds," said Sanjay Prakash, chief executive officer at HSBC Asset Management. "There is a clear arbitrage opportunity which is drawing foreign funds into t-bills."

India has 506 registered foreign institutional investors who have $16.5 billion in assets, mainly in shares.

"The cost of dollar hedging has fallen dramatically, while the interest rate outlook locally remains positive," Mathur said.

Hedging costs

Rupee premiums on the forward dollar, an indicator of hedging costs, plunged to lifetime lows last week reflecting a bullish outlook for the rupee against the weaker dollar.

The one-year forward, used by a foreign investor to hedge a 364-day t-bill investment, was at 1.3 per cent on Thursday, off a historic low of 0.15 per cent on May 21, but down from 2.37 per cent a month earlier and 5.79 per cent a year ago.

The rupee was at 47.03/04 per dollar in morning trade, up nearly two per cent since January 1 after notching its first annual rise in 2002 when it gained 0.55 per cent.

Analysts say hopes of a cut in the short-term repo rate from five percent in the next few months and easy liquidity due to robust foreign exchange inflows would make t-bill investments more attractive.

International rating agency Moody's places the government's local currency debt rating at Ba2 while Standard and Poor's has a BB+ local currency long-term sovereign rating and a 'B' short-term credit rating.