Money may be fleeing from Fixed Maturity Plans (FMPs), but all debt is not being shunned. In fact, there two categories of debt funds that are vying for investors' attention: gilt funds and income funds (medium- and long-term debt funds).
Gilt funds (category of funds investing in long-term government paper) have delivered impressively. As on December 10, 2008, the category of gilt funds delivered an annual return of 16.53 per cent, beaten only by the Gold ETF category. Ever since interest rates began to ease, the yield of 10-year GOI securities declined sharply. This led to a neat gain of 13.13 per cent between July 14 and December 10, 2008. But going ahead, one is not too sure. The issue of whether or not to consider an investment in gilt funds would depend on whether yields of G-Secs would continue to decline.
On the other hand, we have debt funds which seem to be the best bet in the current macro economic scenario. On November 24, 2008, ICICI Prudential Mutual Fund sent a note advocating debt funds keeping in the mind the current economic environment. According to them, the 10-year AAA rated corporate bond spread was at a very high level. On 29 July, 2005, the spread between 10-year gilts and AAA-rated corporate bonds was 58 bps. It rose to 138 bps on July 11, 2008 and 396 bps on November 21, 2008. Now, in a falling interest rate scenario, the fund house expected the spreads of higher rated PSU bonds and corporate bonds to decline. According to them, income funds provide an excellent opportunity to capture this trend.
We spoke to various fixed income fund managers and asked them whether investors should consider gilt or income funds. They seemed pretty unanimous on the fact that it would be unwise for investors to park money solely in gilt funds. Rather, they suggested income funds that invest in both, gilts and bonds.
Why interest rates may fall
Global central banks have been cutting interest rates in order to ward off recession fears. Their main focus is now on pumping liquidity in the system to revive their respective economies. India is no exception.
Given the global slowdown concerns, commodity prices are likely to remain subdued and moderate over the coming months. In India, inflation has been easing and economic growth is slowing down. GDP growth forecasts have fallen from the earlier estimates of 8-9 per cent and now vary between 6 and 8 per cent
.The Reserve Bank of India (RBI) has changed its stance to a growth bias and the central bank is looking at easing liquidity conditions and enhancing credit flows. Between April and September 2008, the RBI had delivered 150bps of CRR hikes and 125bps of repo rate hikes. The tight monetary policy coupled with global turmoil had started to adversely affect the economy by causing tightening of credit conditions and high interest costs.
In October 2008, the RBI cut the CRR by 350bps and the repo rate by 150bps. On December 6, 2008, the RBI reduced the repo rate by 100 basis points from 7.5 per cent to 6.5 per cent and the reverse repo rate by 100 basis points from 6.0 per cent to 5.0 per cent (effective December 8, 2008).
This has set the stage for falling interest rates.
Ritesh Jain, Head - Fixed Income
Canara Robeco Mutual Fund
In the near term we do expect the yields of G-Secs to drop by 25 bps (against closing on December 8, 2008). The 10 year G-Sec yield could top at 6.40 per cent. Fresh borrowings by the government reduce the chances of the yield dropping below this.
Gilt funds could provide opportunities arising out of volatility in trading. But there is no significant upside left for capital gains. Income funds are better placed than gilt funds for 2009. Corporate bond spreads over sovereign yield are at 350 bps. These spreads have to reduce going forward. So income funds would capture the fall in the yield curve itself and also the opportunities of further spread reduction. Also, the carry yields in income funds provide a cushion for any downward pressure arising out of the strengthening of the yield curve or volatility catching the position on the wrong foot.
A. Balasubramanian, CIO
Birla Sun Life Mutual Fund
The broad direction for the interest rate is downwards. Commodity prices coming down not only help bring down inflation but also the overall fiscal situation due to less issuance or, rather, no issuance of, oil bonds and fertiliser bonds as part of the government subsidies. The negative outlook on the overall growth in the Indian economy in particular and the global economy in general essentially will ensure that the policy environment for interest rate will remain benign. One should not be surprised if the 10-year benchmark touches its earlier low of 2003 purely on the back of these developments.
But investors should look at a combination of gilts and corporate bonds. Income funds take interest rate calls by investing in both. During the period of credit crisis globally and domestically, credit spreads for corporates have gone up beyond the historical high level reflecting extreme level of pessimism on the credit market. However, this might change for the better on the back of falling inflation and RBI action in terms of providing liquidity as well as lowering interest rate. Therefore, one should look at investing in income and gilt funds.
In probability, the income funds could outperform gilt funds though credit risk remains in income funds which otherwise is not there in gilt funds.
Sujoy Das, Head, Fixed Income
Bharti AXA Investment Managers
Demand destruction due to high interest rates in the first half of the year and the global liquidity crunch has resulted in corporate India slowing down further.
Though the GDP growth figures for Q2FY09 came at 7.6 per cent YoY, corporate India is going to slow down markedly in FY10 with GDP growth coming down close to 6 per cent. Inflation over the next three to four months is likely to come down significantly with correcting local food prices and declining commodity prices.
Over the same time, the rupee is likely to remain under pressure till the dollar squeeze continues and the global credit crunch stabilises. The pace of depreciation is expected to slow down with the RBI showing its intent by supporting the rupee at crucial levels.
In the last two months, the RBI has reacted to this scenario by vigorously cutting the CRR from 9 per cent to 5.50 per cent and the repo rate from 9 per cent to 7.5 per cent, coupled with a slew of liquidity enhancing measures for banks, mutual funds and NBFCs.
The panacea during such periods is fiscal and monetary stimulus for the economy. In our case, the allowances for fiscal measures are limited. So the central bank will have to resort to monetary measures. With inflation under control and growth faltering, RBI will continue to cut key interest rates. In the next year we expect RBI to cut the reverse repo by 100-150 bps.
We are in a scenario where interest rates are going to head southwards. During this time period, investors in income funds with decent interest rate durations can look forward to capital appreciation due to falling interest rates.
Nandkumar Surti, CIO - Fixed Income
JP Morgan Mutual Fund
Yields on government bonds will drop further as inflation drops further. A global slowdown and a slow domestic economic recovery should be supportive of the bond markets.
If investors want to invest in gilt funds, they should do so with a 12-month perspective. But we think an actively managed bond fund, with the ability to switch between corporate bonds and gilts, will perform better than a gilt fund, per se. This is because the bond funds will benefit from corporate spread compression as well as the lower interest rate scenario.
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