‘Short-term funds look attractive for a six-month horizon'

With the RBI hiking policy rate hikes more steeply to arrest persistent inflation, what should be the strategy of retail investors when they choose debt funds? Mr Kumaresh Ramakrishnan, Head of Fixed Income, DWS (Deutsche Asset Management), India tells us why investors may be better off holding short-term funds currently. He also gives his views on corporate bonds and NCDs, considered alternative investment options to debt funds.

Excerpts from the interview:

Post the 50 basis points hike in repo rates by the RBI, what are the products that debt investors should look at? Is there further scope for deposit rate hikes ?

Since it appears that we are probably in the last phase of the rate hike cycle with rates close to their highs, we would recommend that investors actively look at products such as short-maturity funds.

Given that most of the rate tightening is behind us, the volatility in these products is relatively low. Apart from relatively high accruals, these funds offer a scope for some capital appreciation if the interest rates were to start declining. With a six month horizon, short maturity funds look very attractive vis-à-vis other options.

While banks are likely to increase their lending rates in order to preserve margins, the scope for further increase in term deposit rates seems low, given that higher rates could impact credit offtake leading to lower credit demand. RBI has also lowered its credit growth target for fiscal 2012 by 100 basis points to 18 per cent in the latest policy.

Indian companies are looking at retail debenture (NCD) issuances to raise monies. Are these instruments an alternative to debt funds?

Debt funds offer higher liquidity to investors and a more diversified portfolio with relatively lower risk levels. Retail NCDs may be more suited for investors with a higher risk appetite, given their higher illiquidity and risk levels.

Furthermore, income from debt funds are taxed at lower rates compared to income from bank deposits and NCDs. Hence, investment in debt funds may not be strictly comparable to those in retail NCDs.

When can an investor shift from short-term to long-term bond funds?

While we are strongly recommending short-term products given their attractive ‘carry', investors with a relatively longer investment horizon can start considering medium / long term funds, following the recent rate 50 bps rate hike. Possibility of further aggressive tightening has meaningfully declined post the 50 bps rate hike, which should lead to stabilization in the medium term yields.

In our own DWS Short Maturity Fund we had an average maturity of around 0.75 years as on June 30, 2011. We may consider raising the average maturity in the coming months as more clarity emerges on the macro front. The fund was well positioned with its relatively short average maturity enabling it to benefit from the spurt in yields post the 50 bps rate hike.

What about ultra-short-term /floating rate funds, which have done better than short-term funds?

Their outperformance was partly because of the inverted yield curve for brief periods, as witnessed between December 2010 and March 2011. The yield curve is now normalising, with the onset of improved liquidity conditions. In this scenario, short-maturity funds have already start out-performing ultra short-term funds over last few months.

Will gilt yields rise as the Government borrowing overshoot because of part-waiver in fuel taxes?

As we stand right now, the government seems confident of maintaining the fiscal deficit within the budgeted levels. There has, however, been some reduction in duties and that would mean revenue loss for the government. It may have to compensate this loss from some other revenue sources.

The tax collections in June have been quite robust, in both ‘indirect' and ‘direct' taxes. At this point, we think it is premature to forecast a slippage in terms of borrowings from the government.

There has been a fall in issuances in corporate bonds. Is this a function of low demand?

Rising yields have led to risk aversion among investors who have preferred to stay at the short-end end of the curve. This, in turn, has led to relatively lower demand for longer-dated bonds.

Data show that there is some deferment in capex by a lot of large corporates. As rates continue to rise, the biggest threat is to the investment cycle. Also, if one looks at GDP in the fourth quarter, there is some slowdown in terms of investment cycle. The reliance of markets, in terms of funding, has been more towards working capital.

DWS's long-term and gilt funds have under-performed their respective benchmarks? What is the reason?

The long-term performance of our bond fund has been quite good. In fact, over 3, 5 and 7 years, DWS Premier Bond Fund has been one of the top-performing funds.

Having said that, the fund suffered a bit in last few months because of the sharp rise in long-term interest rates. The long-term bond and gilt funds typically run relatively longer average maturities and, hence, felt some impact of rising yields.

However, we have since lowered the portfolio maturity of the bond fund, which should reduce its sensitivity to rate movements. Going forward, the fund is well positioned to benefit through accrual strategies, as bond yields stabilise at higher levels.

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