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Returns Nudge Down

Amid the receding hopes of a near term rate cut, bond rally slows down

The auction outflow of Rs 5,000 crore sent call rates soaring this week, which pierced the 9 per cent barrier after a long gap. The auction outflow coincided with the end of the 15-day reporting cycle and hence, the last-minute rush for funds by banks pushed up call rates. The Reserve Bank pumped in close to Rs 2,000 crore with reverse repos to cool down overnight calls. However, call rates could remain firm at the beginning of the reporting fortnight next week.

The auction of the 2011, 9.39% paper evinced keen interest with heavy oversubscription and completed 58% of the government's borrowing programme. The auction of a 10-year bond was in line with the market's expectation, which has shown little appetite for longer-dated securities. With sentiment subdued for bonds at the longer-end, sovereign auctions could remain concentrated at the shorter-end of the yield curve.

The week saw a sharp fall in returns from debt funds as receding hopes of a near term rate cut slowed down the bond juggernaut. The average gain for the category of open-end debt funds was a paltry 0.13 per cent against 0.55 per cent in early July. While bond prices are still rising, the sharp surge witnessed some time back has surely disappeared. Thus, returns are now expected to nudge down and it is time investors re-aligned their expectations with little weight for past returns.

Can of Worms at Financial Institutions:
The ghost of Cyberspace has opened a Pandora's box and may prove to be a nightmare for financial institutions. The RBI has already initiated an inquiry to trace banks' tainted investments. On the other hand, investments worth Rs 1100 crore have turned sticky for IDBI and ICICI. IDBI was recently downgraded due to deteriorating quality of its assets. Worse, the third public financial institution of IFCI has also been put on rating watch after a delay in its repayment obligation. The largest public mutual fund, Unit Trust of India is already under fire for its dubious investments.

As skeletons tumble out from the cupboard, it is bound to shake the confidence of the financial industry. While guilty should be punished for causing willful loss, it should not impact lending of funds to the genuine promoter. Else, this could hit the revival of the economy as wary banks shy away from sanctioning loans under fears of prosecution.

Outlook
Systemic risks may now start to hound the bond markets as even private finance companies grapple with loss on equity investments. Already, Tata Finance has been put on rating watch. Thus, the coming weeks could see a flight to quality as investors jettison suspect debt securities for genuine triple A bonds and government securities.

On the other hand, banks could start to cut their deposit rates now with little credit offtake and sharp drop in yields on sovereign bonds impacting their spread. For instance, most banks offer returns in the range of 8.5 to 10 per cent on their fixed deposits above one-year while the yield on ten-year paper is currently around 9.3 per cent. Needless to say, this is unsustainable and could create a severe asset-liability mismatch. Thus, in the current scenario, open-end debt funds are an ideal investment vehicle for investors. While this category already scores over fixed deposits for higher returns, tax-breaks and easy liquidity, the charm increases further if banks bring down deposit rates. In a deteriorating economy, investors need to thoroughly scan the portfolio of their debt fund and make sure that the fund manager is not taking undue risk to generate returns