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Debt Funds Still Partying

Debt funds are in a partying mood right now thanks to the recent rate cuts, but how long will this party continue?

The debt fund party continues. While December was the best time that debt fund investors have ever had, the first days of the new year have also turned out to be a bonanza. Return from fixed income funds shot up again with the latest rate cuts that the central bank announced on the evening of January 2. Since the rate cuts were widely anticipated, some of gains preceded the actual announcement. Long-term government security funds registered an average gain of 1.63% on Friday, while medium-term bond funds gained 0.79%.

These are one-day average for the entire category of funds. In fact, the average hides as much as it reveals. Of the 48 gilt funds that Value Research classifies as medium to long-term, as many as 14 had returns of more than two per cent on a single day while the top fund gained by more than five per cent. At the bottom end, there were just eight funds that gained less than one per cent.

The credit squeeze in October has triggered a series of action by Reserve Bank to ease liquidity in the system. Since September last year till January 2, Cash Reserve Ratio has been reduced by 4 per cent from 9% to 5% in five successive reductions. The repo rate, which is the rate at which RBI lends to banks, has also been reduced by 350 basis points to 5.5% now. The Reverse Repo Rate, the rate at which banks park their surplus funds with the RBI, has been reduced by 200 basis points to 4% now.

This rate cuts in a brief period has lead to the rally in the government bond prices. The yield of 10-year G-Sec fell significantly from 8.68% on September 1, 2008 to 5.35% on January 2. Fixed income funds of all kinds have substantially benefited. The biggest beneficiaries were long-term gilt funds which are up 22% in the past 3-months.

Currently, the general view is that interest rates are on the way down. As the tough times continue, there is little chance of the central bank raising interest rates in the economy. As a result, gilt investments have become a one-way bet, at least for the time being. Fund managers will plan on just staying at the longest maturities and wait for rate cuts. However, this is not the classic rate cut pattern that we saw in the early part of this decade. This is an emergency action that the RBI is taking to counteract the severe credit squeeze in the economy.

Compared to the earlier periods when rates were cut, the entire fixed-income market is not operating normally. For example, as the yield of government securities have fallen in line with the RBI's rate cuts, the yields of corporate bonds have not kept pace. Among other things, the spread between gilts and corporate bonds is a measure of the additional risk that investors perceive in corporate bonds vis-à-vis gilts. This is exactly what has been happening in the US and Europe for a few months now. Investors will keep piling into government securities.

This has important implications for investors in fixed income funds. As I've written earlier, such funds are heading not for good times, but volatile times. Basically, money is not flowing normally through the economy. This will result in the occasional bonanza, as well as the occasional disaster.