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Which Debt Fund To Invest In?

With interest rate hikes imminent in the coming months, investors should avoid long term debt. Short term bond funds are the way to go

This was the cover story in the 15 November - 14 December, 2009 issue of Mutual Fund Insight magazine.

Apparently, the worst of the financial crisis and recession is behind us. Which, in turn, throws up significant questions concerning the future. Central banks across the world find themselves in a quandary. If they raise rates too early, they may stymie the recovery now underway. Too long a wait could stoke up inflation and create asset bubbles.

In August, Israel was the first country whose central bank raised interest rates since the global economic crisis of 2008. Its key rate rose from 0.50 per cent to 0.75 per cent, continuing to represent an expansionary monetary policy. Israel’s central bank was clear that it needed to strike a balance between the need to moderate inflation and continue to support the recent recovery in economic activity. In October, Australia followed and in November, Norway’s central bank followed suit.

In India, the Reserve Bank of India (RBI) signalled the start of its exit strategy by ending its liquidity support measures and hiking the SLR. So what does this mean for investors? Will interest rates rise in the immediate future? Where must they invest? Let’s look at this issue by first understanding why interest rates did not rise in the latest monetary policy.

The RBI’s balancing act



The RBI has three prime objectives — price stability, financial stability and growth. However, the immediate priority varies from time to time. Currently, price stability and supporting growth is the prime consideration. 

A worrisome factor is the inflation rate. After declining for 13 weeks in a row between June and August 2009, the Wholesale Price Index (WPI) rose by 1.21 per cent for the week ended October 10, 2009. It is going to keep on its upward trend. By the end of this financial year, it could touch 7 per cent, which is higher than the RBI projection of 5 per cent. As for the Consumer Price Index (CPI), it has been in double digits for quite a while. So logically, the RBI could have hiked rates up a bit to control inflation. But as mentioned above, price stability is not its only objective. An immediate increase in interest rates as a pre-emptive strike against inflation would upset the recovery and growth momentum. Hence the RBI chose to leave key rates unchanged for now. Tightening at this time may probably not do much in terms of reining in inflation, but it would certainly hurt growth.

Despite signs of pick up in capital inflows, the RBI is concerned about the strength of recovery. Annual credit growth for the week ended October 9, 2009, was 10.75 per cent, a 12-year low. Inspite of repeated rate cuts, flow of credit to the private sector remained sluggish due to subdued overall private consumption and investment demand. Moreover, the combination of drought and floods is likely to cut the kharif crop (summer crop) and drag down the overall growth rate. If conditions remain favourable and we have a good rabi crop (winter crop), it would partly reverse the damage caused by the shortfall in kharif production.

Another factor to consider was that European economies and the U.S. are not increasing interest rates and are continuing with their loose monetary policies for now. So a rate hike in India would attract larger capital flows and strengthen the Indian currency. A strengthening rupee would lead to the RBI buying dollars from the market (as a stronger rupee depresses exporters’ income). So when it buys dollars, an equivalent amount of rupees flows into the system. This would lead to more liquidity in the system. 

Having presented all these arguments, there’s no wishing away inflation or the excess liquidity in the system. The RBI will have to introduce measures to deal with both. Inflation, as mentioned above, is a very serious concern and is only going to move in one direction, up. Excess liquidity always has a significant impact on inflation with a lag effect. So if the RBI wants to maintain price stability it must take out the excess liquidity. Moreover, when there is a lot of liquidity in the system, we are vulnerable to asset price bubbles. The real estate and the stock market are both showing signs of overheating. The only option for the RBI is to suck out liquidity and make money dearer. There is no way a rate hike can be avoided.

Which brings us to the next issue of whether or not such a move would hinder growth. The economy is not on a firm growth path. But neither is it still in the doldrums. Industrial production data in the second half of 2009 provides optimism on that front. The Index of Industrial Production (IIP) in August 2009 grew 10.43 per cent, a 22-month high. Foreign trade continues to be sluggish. There is no growth yet in exports, but the decline is less severe. Exports slumped by 19 per cent in August 2009, a lot less than the 33 per cent fall seen in March and April this year. In effect, the jury is still out on how the economic recovery will pan out. But the consensus is that rates will rise, though gradually.

When will rates begin to rise?



If rates have bottomed out, then the logical question is: When will they be increased? Frankly, there’s no telling. The RBI could act swiftly if inflationary pressures rise. The RBI Governor D Subbarao was clear in his statements that inflation is a prime concern and the central bank will utilise the monetary policy as and when it believes it will be effective in reining in inflation and anchoring inflationary expectations. Where a time frame was concerned, all he said was that it is going to be months, and not years and sooner than most advanced countries. 

Since the CPI and WPI forecasts have gone up sharply, there could be further tightening by December if the situation turns alarming. Or else, early 2010 one can expect the first hike in policy rates. Says one fund manager, “A year down the road, I cannot predict where interest rates will be. At one time we could predict inflation and GDP. Not any longer. Three months ago, the RBI put inflation at 4 per cent for March, increased it to 5 per cent, and now has put it at 6.5 per cent with an upward bias.” But he was pretty sure that there would be a CRR hike by January 2010 of 20 basis points.

His thoughts are echoed by quite a few. The general consensus is that the RBI will not consider any dramatic hike in the next two quarters, because for that to happen, the economy needs to see genuine credit growth.

RBI’s first move will be to suck liquidity out of the system through a CRR hike. This could happen by December or early January.

The RBI would wait for another quarter to see growth numbers being reinforced before going for a rate hike signalling upward movement of interest rates. So this first hike could take place in the very first quarter of 2010.

By March 2010, the 10-year G-Sec, which is the benchmark and basis for pricing all the other asset classes, would probably trade in the range of 7.25 to 7.75 per cent, currently at 7.30 per cent (early November), up from a historic low of 4.86 per cent (early January).

So if interest rates are set to rise, it would not be wise to park your money in long-term debt right now (see: Checklist for investors). Do that when rates are at a high or have peaked. We suggest that you park your money in short-term bond funds. In the next few pages, we list some options for you to consider.

Checklist for investors



It is always wise to keep some portion of your assets in debt funds and never sport an all-equity portfolio.

With rates set to rise, there is no point in taking any interest rate risk right now. Avoid long-term duration funds.

Investors should now consider short-term bond funds.

Consider long-term debt funds when interest rates are at a high or have peaked. 

When interest rates do rise next year, more fund houses will come out with Fixed

Maturity Plans (FMPs), which can also be considered.

2010 will be far more volatile for the debt market than 2009 was. The RBI will start with a CRR hike before moving on to a rate hike.

The RBI’s ammunition



The central bank started its expansionary monetary policy exactly a year ago. The first step towards liquidity management was adjusting the SLR. Between October 2008 and April 2009, the RBI lowered its Repo Rate (the rate by which it infuses liquidity in the system) from 9 per cent to 4.75 per cent. The Reverse Repo Rate (the rate by which it sucks out liquidity) went down from 5 per cent to 3.25 per cent while the CRR dropped from 9 per cent to 5 per cent. Though the RBI never touched any rates in its latest credit policy, the SLR adjustment was a clear signal that it is once again reverting to the pre-crisis stance and indicating a reversal of policy. In the coming months, these are the rates that could start rising indicating a higher interest rate scenario.

5%



Cash Reserve Ratio (CRR) is the amount of funds that the banks have to maintain with the RBI

4.75%



Repo Rate is the short-term rate at which banks borrow from the RBI

3.25%



Reverse Repo is the rate at which the RBI borrows from banks

25%



Statutory Liquidity Ratio (SLR) is part of the deposit that banks are mandated to maintain as cash or park in government securities



(up by 1% in the latest monetary policy)

The Final Selection



1st Filter: The entire universe of debt funds



 Exclusion: Ultra short term and gilt funds



 Exclusion: Funds with a history of less than 18 months

2nd Filter: From the list arrived at after the exclusions were taken into account, the ones selected were those with an average 1-year maturity of less than 12 months and whose maximum maturity had not exceeded 24 months.

3rd Filter: The final selection of funds were those that scored the highest based on returns and expenses. The parameters used for arriving at the score were the returns over 1 month, 3 months, 6 months and 12 months. The Expense Ratio was also given adequate weightage when arriving at the score.

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