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2013 outlook: Invest in debt to gain from fall in interest rates


Debt investors may be spoilt for choice in 2013. With all likelihood of interest rates falling, debt mutual funds are expected to give handsome returns if past instances are anything to go by.

Turning Cycles

Between 1994 and 2003, when interest rates were falling, debt mutual funds gave high double-digit returns. This was followed by the 2004-08 economic boom, forcing the Reserve Bank of India, or RBI, to increase the repo rate, at which it lends to banks, from 4 per cent to 9 per cent. This gave a body blow to debt mutual funds as bond yields and prices move in opposite directions. When yields rise, prices fall. This is because when new bonds with higher yields come to the market, those with lower yields become less attractive and lose value. When this happens, funds holding long-tenure bonds see erosion in their net asset values or NAVs. This is what happened in 2004-08 when interest rates were rising.

The 2008 global financial crisis changed things with the RBI slashing the repo rate from 9 per cent to 5 per cent to revive the economy (See Interest Movement). As a result, in 2008, long-term gilt funds (holding longtenure G-Secs) returned more than 20 per cent on an average, with the best performing ones rising up to 28 per cent.

THE GILT EDGE: Gilt and income funds have done better than the other categories over the last one year

Since early 2010, the RBI has been increasing rates to cool inflation. Although investors have gained from fixed maturity products- bank fixed deposits and fixed maturity plans (FMPs) offered by mutual funds-which are pegged to the general interest rates, income and gilt funds have suffered. For instance, in 2011, the returns from gilt finds ranged from -7 per cent to 5 per cent.

What next?

In spite of high inflation, experts expect some monetary easing in 2013, as high interest rates have put the brakes on economic growth. "The extent of easing will be determined by fiscal deficit, commodity prices and growth," says Swapnil Pawar, chief investment officer, Karvy Private Wealth.

Among the three, fiscal deficit is the most important as government borrowings to bridge it put upward pressure on interest rates.

"The government's finances will remain under pressure. It will find it difficult to meet the fiscal deficittarget," says Ritesh Jain, head of investments, Canara Robeco Mutual Fund. Hence, the RBI may not cut rates aggressively but go for open market operations (OMOs), in which it buys government bonds in the open market, injecting liquidity. "If the RBI does OMO buybacks, yields on long-tenure securities may fall by 10-20 basis points or bps," says Jain.

A fall in yields will push up bond prices and hence the NAVs of debt funds. Lakshmi Iyer, head, fixed income and products, Kotak Mutual Fund, says interest rates depend on growth and its impact on inflation.

"If high inflation persists, we do not expect rapid monetary easing (less than 100 bps cut next year). However, should inflation be reined in, the central bank may take a progrowth stance (more than 150 bps cut)," says Pawar.

As far as liquidity is concerned, the RBI will keep it in the comfort zone. Hence, in 2013, long-term rates are likely to fall while shortterm rates will be a function of liquidity and hence remain rangebound. "We could see three-month commercial deposits at 30-50 bps over the repo rate and one-year commercial deposits at 50-75 bps over the repo rate," says Jain.

BEST OF THE LOT: Top Gilt, Income and Short-Term Funds in the last three years

Keeping these things in mind, let's look what will be the best debt options in 2013 -

Debt Mutual Funds

A fall in rates will be good for long-term gilt and income funds. Experts say actively-managed income and gilt funds work well for those with an investment horizon of more than a year. Iyer of Kotak Mutual Fund says those with a horizon of up to six months should invest in ultra short-term funds whose average maturity period is three-six months. Due to their short duration, these funds carry a low interest-rate risk. Those looking at a slightly longer period of up to one year can put money in short-term funds which invest in corporate bonds. Most such funds have maturity of two-three years.

In fact, most funds have already factored in lower interest rates. Long duration gilt and income funds have returned more than 10 per cent in the last one year. Short-term funds, too, are not behind.

Among the top performing gilt funds, Baroda Pioneer, Kotak, Birla and IDFC have delivered 9 per cent a year over the last five years. Kotak's Gilt Investment Plan has outdone peers by a big margin, delivering 17 per cent returns over the last one year. The fund's average maturity is 12.39 years, which means a big chunk of funds is invested in long-duration government securities.

"The fund's active management of government securities and duration has helped it generate alpha returns," says Iyer.

In the long-term income fund category, SBI's Dynamic Bond Fund has returned 9.5 per cent a year over the last three years. It's followed closely by the rest. Short-term funds have also been performing consistently over the last three years.

Fixed Maturity Products

Ideally, investors should lock into high-yield fixed income instruments such as bank fixed deposits (FDs), corporate deposits and FMPs offered by mutual funds as early at the start of the rate-cut cycle as possible. This is because all these three are pegged to the general rates and so will fall with the latter.

FMPs are also offering up to 9 per cent. For short-term investments, State Bank of India is offering 7 per cent for up to one year.

Those willing to take additional risk can also look at debentures issued by private and public limited companies. Such issues are typically privately-placed, wherein an intermediary such as a broking house offers these to clients on behalf of the company. "In a scenario where we expect a fall in interest rates, investing in fixedincome securities such as debentures is a good idea," says Iyer of Kotak Mutual Fund.

Although these debentures can give high yields (above 12 per cent), they come with a few risks. Jain of Canara Robeco Mutual Fund says investors must go for highly-rated debentures (AAA / AA+) as the credit quality of India Inc is in a much worse shape than three-four years ago. Also, such debentures often become illiquid.



UP TO THREE MONTHS: Liquid-plus funds and SBI fixed deposit 
ONE-SIX MONTHS: Ultra short-term funds where the average maturity is three-six months. 
UP TO ONE YEAR: Short-term funds which invest in corporate bonds. 
ONE-THREE YEARS: Long-term debt funds, tax-free bonds, NABARD bonds, specialised long-tenure funds 
THREE YEARS AND ABOVE: Long-term debt and gilt funds, tax-free bonds, NABARD bonds, specialised long-tenure funds