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Time to Shuffle the Pack

Tanvi Varma/Money Today        Print Edition: March 2012

There are signs that India's central bank, the Reserve Bank of India, or RBI, will soon be reversing the rate increase cycle it put in motion in March 2010. Whatever this may mean for your other investments, one thing is clear - your fixed income portfolio needs a tweaking.

With inflation easing, the RBI kept rates unchanged in the mid-quarter review of the monetary policy on 16 December 2011. This was the first sign that it is worried over slowing growth.

In its third quarter review on 24 January 2012, it cut the cash reserve ratio, or CRR, the funds banks have to keep with it, by 50 basis points, or bps, which is expected to ease money supply and inject Rs 32,000 crore into the system.

"In the 20 months since March 2010, the benchmark 10-year bond yield has risen 150 bps from 7 per cent in 2010 to 8.5 per cent," says Dhawal Dalal, fixed income fund manager, DSP Blackrock (DSPBR)

Bond yields and interest rates move in tandem.

FUND BASICS
Rise in bond yields hits returns from debt funds. Here's how it works. As bond prices rise, bond yields fall.

Simply put, in a rising rate scenario, when a new bond with a high yield (let's say 8 per cent) comes to the market, the older bond (with a 7 per cent yield) becomes less attractive, due to which its market price falls.

So, funds holding older bonds see a fall in net asset values, or NAVs. This means if rates are rising, it makes sense to buy bonds with shorter maturities to benefit from higher yields expected in the immediate future.

This can be seen in the performance of debt funds over the last three years, when long-term debt and gilt funds underperformed short-term and liquid funds. Dalal says in such a situation, it is difficult for any long duration asset to do well. This, say experts, is likely to change soon.

CRYSTAL GAZING
The recent CRR cut indicates interest rates are likely to begin to fall in the second quarter of 2012. The reason is that inflation, which stayed high throughout 2011, is easing. Wholesale price inflation, the benchmark price index, rose 6.5 per cent in January as against 7.47 in December 2011. This is the lowest in 26 months.

Some people, though, are still cautious on the RBI's next move. "Although the RBI has shifted focus from inflation to growth, it is still likely to factor in the high inflation level while taking decisions," says Dalal of DSPBR.

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Investors who do not mind volatility can invest in longer tenure funds gradually to gain from the likely rise in G-Sec prices over 12 months.

DHAWAL DALAL

Fixed Income Fund Manager, DSPBR

"Further, this year and the next, the country's fiscal deficit is likely to worsen. This may result in higher government borrowing. Market participants expect the RBI to cut rates and inject liquidity during the first half of the year. However, the quantum will depend on inflation and commodity prices. Taking these factors into account, we expect the 10-year yield to trade between 7.75 per cent and 8.25 per cent in the first half and 8.25-8.75 per cent in the second half of the year," says Dalal.

At present, the 10-year yield is 8.1-8.2 per cent.

Countries the world over are loosening monetary policies to push economic growth. The inflationary trend has reversed in many parts of the world with commodity prices falling. The US Federal Reserve has said it will hold interest rates near zero until at least 2014. In India, too, chances are that interest rates will be eased as the RBI tries to push up growth.

Suyash Choudhary, head of fixed income, IDFC MF, says the RBI may start cutting rates somewhere in the early part of the next financial year. However, if international uncertainties persist, the process may start sooner, he says. As far as bond markets are concerned, says Choudhary, short-term rates will fall significantly and much faster than the long-term rates.

WHERE TO PARK?
It is critical that investors decide their risk appetite and investment horizon before deciding where to invest.

"The per unit duration risk taken in a short-term fund may be a very attractive option over the next year," says Choudhary. Investors with limited risk appetite should invest in products such as short-term funds which have a minimum holding period of six months.

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Although we are seeing the onset of rate cuts, this time the rate cut cycle is unlikely to turn as fast as it did in 2008.

Deepali Bhargava

Chief India Economist, Espirito Santo Securities

"However, investors who do not mind volatility in the interim can choose to invest in longer tenure funds gradually to gain from the expected rise in prices of government bonds over the next 12 months," says Dalal of DSPBR.

"As such, when interest rates start falling, we could see a bond fund give double-digit returns if there are no other macroeconomic shocks," he adds.

"Having said that, invest at a measured pace as government securities, or G-secs, will continue to remain volatile, with a high fiscal deficit resulting in additional supply of government bonds," says Dalal.

A lump-sum investment in longer-term debt funds is an option for those who have a long investment horizon and a good appetite for volatility.

FUND IMPACT
The expectation of rate reversal has already begun to be priced into the performance of various debt funds. Short-term debt funds have delivered a return of 9.3 per cent over the last one year, followed by funds in the long-term category, where income funds have returned 9.1 per cent.

Dynamic bond funds have delivered 11-12 per cent. These funds actively manage interest rate risk by changing the duration of bonds that they hold in line with the interest rate cycle. They mimic a cash fund (with 100 per cent into cash) when interest rates are rising, thereby preserving capital, and can generate the attractive returns of an income fund (being fully invested in 10-year bonds) when interest rates are declining.

Dalal says dynamic funds are ideal for investors with a low risk appetite, especially those who prefer income funds and like higher credit quality and lower volatility. Investors who can tolerate market volatility can go for income and gilt funds.

Liquid fund yields are close to 8.5 per cent owing to the repo rate being at 8.50 per cent, liquidity deficit and banks' refinancing requirements. "However, with pressure from these factors expected to abate during the first half of the next financial year, we expect liquid fund yields to fall," says Choudhary.

PIECE OF PAST
India saw a secular rate easing between 2000 and 2004 when the benchmark 10-year G-sec yield fell from 12 per cent to 5 per cent. During this period, long-term debt funds delivered an average return of 13 per cent on an annualised basis (See Over the Years).

Then between 2004 and mid-2008, yields rose from 5 per cent to 9.5 per cent, when long-term debt funds returned 5 per cent on an average. However, over five years, these funds returned 7-8 per cent.

Then came the global financial crisis of 2008 after which the repo rate went down from 9 per cent to 4.75 per cent (See Rate Curve).

"Although we are seeing the onset of rate cuts, this time the rate cut cycle is unlikely to turn as fast as in 2008," says Deepali Bhargava, chief India economist, Espirito Santo Securities.

Then, the rate cut cycle was short, just six months, with an initial 100 bps cut and cumulative cuts amounting to 425 bps. That was in response to the fear generated by the global crisis. The backdrop is serious this time too but very different: the euro zone problems are turning out to be more complex and long-drawn.

"In the absence of a systemic crisis caused by a tail event in Europe, we think a better parallel for assessing the impact might be the rate cut cycle of 2001-2004, which was far more gradual, extended over three years, and less aggressive, with a cumulative cut of 400 bps," she adds.

OTHER OPTIONS
If you are looking at fixed income investment options that offer guaranteed returns, you can also lock into the high interest rates being offered by banks and company fixed deposits. Bank fixed deposit rates have moved up from 7.75 per cent in September 2010 to about 9.75 per cent. Although they offer a fixed return, the interest is taxed, which renders them unattractive for those in the 30 per cent tax bracket.

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The RBI may start cutting rates in the early part of the next financial year. However, if global uncertainties persist, it may start sooner.

Suyash Choudhary

Head of Fixed Income, IDFC MF

Another option is the various Non Convertible Debentures (NCDs) being floated by reputed companies that are offering 10-12 per cent per annum with a lock-in period of five years. In fact, many corporate bonds and NCDs offering high interest rates are traded in the market. However, they will have to be bought at a premium as declining interest rates will make them more attractive.

Further, there are bonds by government undertakings that offer around 8 per cent a year. For another tax efficient option, you can look at Fixed Maturity Plans, or FMPs, for one-two years. FMPs give 50-100 bps over fixed deposits and are tax-efficient. Long-term capital gains tax is 10 per cent until the Direct Taxes Code comes into force.

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