‘Short-term funds will minimise damage during rate hikes'

The uncertainty regarding the interest rate direction continues to weigh heavily on investment decisions of fixed-income investors. Business Line spoke with Mr Killol Pandya , Head, Fixed Income, Daiwa AMC, to get an insider's view on debt markets and funds.

Excerpts from the interview:

What is your take on the current debt market scenario??

Inflation, which is one of the big bears the debt marketis facing today, is not looking good.

What is weighing on the debt market is the persistent tightness of market liquidity. We are seeing significant negative liquidity in terms of liquidity adjustment facility (LAF) numbers. This is by design as RBI wants liquidity to be tight.

Global events are also adding to the uncertainity, though we are not seeing too much of an impact of the European debt crisis as none of the Indian debt market participants are directly exposed to European debt. However, the ramifications it has on the equity market and, as a consequence, on the rupee has, in turn, had some implications on the debt markets. If the RBI intervenes to sterilise this depreciation in a major way it will probably mean sucking out further liquidity from the market. That is a worry.

I would like to highlight that we have no control on any of these factors — the inflation numbers that have strong roots on the supply side, the global commodity prices, European debt and the US numbers.

To sum it up, the outlook remains bearish. In its last interaction, the RBI has not given away even a hint that there will be a pause in rate hikes. The door is wide open to take rate action whenever it is appropriate.

What is your expectation in terms of the rate hikes?

The stance of the RBI and the interest rate actions as of now, are far more data-driven than earlier. That increases the amount of uncertainty which we all have to live with. As I mentioned above, we really don't have any control over the macro economic numbers we are talking about. Because increasingly, the RBI itself is looking at data points that really cannot be predicted empirically. Going ahead, if inflation is not coming down, the RBI will be constrained to bring about further hikes. So in the next policy interaction, I will actually be looking at the WPI and the IIP numbers which will be come out in the first half of October.

With inflation expected to rise, how challenging is it for debt fund managers to give positive inflation-adjusted returns?

The market is not expecting the inflation to come down anytime soon. The challenge for the debt managers is to stay invested and to give the sort of returns that would not erode the capital. Every time there is a rate hike there is capital erosion, all other things remaining the same. The only way out for an Indian debt manager is to remain invested in a portfolio which matures really fast. The advantage with that is it will minimise the damage as and when there are rate hikes. Also, you will get an early re-investment opportunity.

Is there a time line post which long-term funds may give better returns?

The point of certain fund categories underperforming for a long-term and therefore meriting an investment doesn't hold good on the debt fund side. As things stand now we will see the inflation numbers coming down and staying down by the end of this fiscal. The RBI rate action will probably stop before that because there is lag effect involved with the RBI's actions. I will expect this scenario (pause in rate hikes) to pan out some time in the next quarter. That is when I would start recommending that people get into long-dated funds. I am not recommending that people try and actively catch interest rates because that doesn't work. But some time early or middle of next quarter is a good time to start investing.

What separates a good fund from a mediocre performer in the liquid fund category given that their universe is only the money market?

The first differentiator that one should look at is the quality of the portfolio. The money market space is not homogenous. There are risky products. There are products which are poor on the credit front. All issuers do not enjoy the same financial strength. Ones which are weak will give higher returns.

But aren't a lot of companies enjoying P1 or P1+ rating in the short run even as their long-term ratings aren't good?

The implication of credit is not really a default credit. All of them are enjoying pretty decent ratings and none of them have defaulted in the long-term. But the thing is that issuers who are enjoying poor credit will not enjoy market liquidity.

The product of liquid and liquid plus fund is to provide liquidity. If you have a portfolio which is packed with instruments giving high returns but that cannot be sold in the market then how do you fund redemptions? To my mind that makes for a poor product.

Coming to size, I don't subscribe to the theory that smaller ones are more vulnerable. It is a matter of proportions. The processes that go into building a fund which is of Rs 5000-crore size is the same that goes into building the Rs 500-crore fund. Diversification/portfolio concentration determines the risk.Even large funds will have portfolio concentration, which is not prudent. And this profile is essentially a function of what a fund manger thinks.

With downgrades on the rise what would be the impact on credit spreads?

The credit spreads for that particular instrument getting downgraded and for the sector perhaps may widen. That is a function of credit downgrade. That is how it should be and that is sign of a healthy market. The way in which mutual funds tend to protect themselves is to be very vigilant regarding credit rating.

As such, credit spreads are very tight. Across maturities, the AAA and gilt spread curve is around 100 basis points. That is not healthy. Such a flat and tight spread curve is a sign of a strained market, which is what I have told you. We are in a strained market experiencing bearishness. Spreads should be higher at the longer end.

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