‘Investors should stick to short-term funds'

India's 10-year government bonds have spurted to highs last witnessed in October 2008. The yields shot up following RBI's increasingly hawkish stance seen in its monetary actions to tackle inflation. Given this backdrop, we spoke to Mr Gautam Kaul , Fund Manager (fixed income) of IDBI AMC, to know the impact of the monetary action on debt instruments and funds and what should be the strategy to be adopted by investors in debt. Mr Kaul's advice to investors is to hold short-term funds until there is a clear sign that RBI is comfortable with the inflation numbers.

What is your inflation expectation?

While headline inflation has come down for the month of April, it continues to be way above RBI's comfort zone. The February inflation was also revised upwards by more than 120 basis points to 9.5 per cent, adding to the concerns.

Even as food and other primary inflation reading have been coming down, there has been rising risk from energy prices and core inflation.

On top of that, you are yet to see the impact of coal price hikes (possibly leading to higher electricity prices) and the recent hike in fuel prices, which will affect inflation beyond April. Petrol prices will affect the inflation by 15-17 basis points.

Our expectation is that May inflation numbers should be upward of 9 per cent. We also see significant revision in March numbers. We expect inflation to be upward of 8 per cent till November 2011.

With inflation getting more broad-based, what kind of monetary policy action do you expect from RBI?

RBI's 50 basis-point hike was more than anticipated and suggests that fighting inflation is the foremost objective of its monetary policy.

Our sense is we will see further hikes, which could be front-loaded. While our base case is 25 basis points each in upcoming policies, you could see another 50-basis-point hike.

The RBI may target inflation as long as the headline number is above the comfort zone.

What is the impact of RBI's monetary actions on short-term and long-term yields? Will they go back to 2008 highs?

Rise in yields in 2008 were not only a function of inflationary expectation i.e. not just domestic factors but also global factors and unusually high liquidity crunch. I don't think we are heading to that kind of highs this time around. There are no systemic issues unless there is any global crisis of the magnitude of 2008. Therefore, I don't think the rates will move that high in terms of yields on government securities and money market papers.

Having said that we expect the long-term yields to be under pressure. The 10-year yield is currently close to 8.3 per cent and may broadly trade in the range of 8-8.5 per cent in the coming months.

What should investors look for in debt funds now?

We still tell investors to avoid long-term income funds. Investors have to stick to ultra-short term funds where the portfolio yields are currently high and the duration risk is low.

Additionally, short-term funds which have relatively low duration can be considered.

Fixed-maturity plans (FMP) can also get attractive as certificate of deposit rates (CD) and commercial paper rates move up.

With one-year CD rates trending up to 10 per cent one may find good appetite for FMPs.

When should an investor shift to long-term debt fund?

Shifting to long-term debt fund should be done when you believe interest rates are peaking. In the current scenario that will happen only if the inflation falls in a sustained manner or if at least the expectation of inflation peaks.

Once you see that the RBI is comfortable with inflation coming down, that is when you will see yields coming down. That is best time to invest in long-term income funds.

Having said that, beyond a point you cannot time too much. For most retail investors the advice would be to allocate some part of one's portfolio to long-term income funds.

They will give returns when most of the asset classes are probably not giving you that much return.

Now that the fixed deposit rates are high and give high degree of safety with less volatility shouldn't one consider FDs over debt funds?

Liquid funds or ultra short-term funds give not only offer high accruals but also provide option of easy liquidity.

In my opinion, both have their place in the investment portfolio depending on the investor's time frame requirements and comfort.

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