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How to Select a Debt Mutual Fund?

Where will interest rates be over the next three years?
Will rates rise over the next year?
Depending on where interest rates are headed, where should I invest?

 

There are some questions that are very difficult to answer. And the ones mentioned above fall bang into that category. Yet, we cannot ignore them because an overwhelming number of reader queries to Value Research have taken on this tilt. Now we certainly understand why readers would want an answer. If you knew interest rates are going to inch upwards, you would put your money in short-term debt funds. Conversely, if they were going to head south, you would lock your money in long-term debt funds. Hence the question: where are interest rates headed?

 

At the start of the year, the consensus was that interest rates would rise. The crisis in Greece has changed the direction of global interest rates. In the last week of May, news flow pertaining to the bail out of Spanish bank CajaSur by Bank of Spain brought to the fore concerns regarding the fragility of Europe's financial system. Soon after fears that Hungary would suffer a Greek-style debt crisis added to global woes. Early April, the 10-year Treasury yield (U.S.) was flirting with 4 per cent. But after the Euro zone debt crisis, investors rushed to safety, which was U.S. debt. As buyers piled in, prices rose and yields - which move inversely to prices - fell. The 10-year Treasury yield, the benchmark for consumer and corporate borrowing, dipped to as low as 3.059 per cent in the last week of May. According to a survey by The Wall Street Journal, the median year-end forecast is around 3.75 per cent, down from the 4.15 per cent prediction that was given at the end of March.

 

Why are we talking of global rates? Because the rates in India will have to be more or less in tandem with the global movement of interest rates. A global low interest rate environment would lead to a flood of financial flows to emerging economies which have higher interest rates, causing rupee appreciation (in India's case) as well as raising the risk of inflation and asset bubbles.

 

The Reserve Bank of India (RBI) has a tough task on hand as it determines the direction interest rates should take. On the domestic front, growth and inflation are exerting pressure on interest rates. Gross Domestic Product (GDP) grew by 8.6 per cent in the quarter ended March 31, 2010, while GDP for the entire year rose at the rate of 7.4 per cent. Accelerated economic growth and inflation are together putting pressure on the RBI to raise rates. The RBI Governor Subbarao has openly stated that though "inflation is not at its peak, it is still higher than we would like it." Unfortunately, the Euro zone's debt crisis is putting a cap on RBI's eagerness to tackle inflation. On May 19, the RBI said that it would raise rates only cautiously even though they were "out of line'' with the key wholesale-price inflation rate, running at 9.6 per cent. Early June, Finance Minister Pranab Mukherjee said that India would not put off interest rate hikes even in the wake of risks to global recovery from the European sovereign debt crisis.

 

The RBI expects inflation to ease around mid-2010 on account of a normal monsoon and moderation in food prices and has forecast the March 2011 WPI inflation at 5.5 per cent. The factors that will determine the direction of inflation include the monsoons, after last year's drought sent food prices sharply higher. Oil prices too are being monitored for their impact on inflation. International crude prices rose from $28/barrel in 2003 to $147/barrel in 2008. Early June 2010, the price dropped slightly below $70/barrel, due to weak U.S. job numbers and warnings about Hungary's economy re-igniting concerns regarding Europe's debt crisis.

 

Meanwhile, there were short-term hiccups in the domestic market. The 10-year benchmark yield (7.80% bond maturing in 2020), which was hovering around 8 per cent end-April, ended at 7.40 per cent on May 24. Of course, that week India's 10-year bonds declined the most in more than a month also on concerns that cash at banks will decrease due to the payment of licence fees for third-generation (3G) mobile phone spectrum and advance tax payments. However, the RBI instantly stepped in and eased rules to boost liquidity at banks to avoid a cash crunch due to these payments.

 

The point that we are trying to make is that there are way too many variables that go into determining the direction of interest rates - domestic and international. It is difficult for an experienced debt fund manager to make such a call, so one cannot expect a retail investor to even venture into that zone. If the days of easy predictability of bond prices and interest rates are over, how should an investor decide where to invest? Purely on the basis of his time frame and his preference for risk. Don't even try to guess where interest rates are headed, just look solely at your requirements and leave the rest to the fund manager's skill. "Too much has been communicated to the investor on the interest-rate cycle. Investors must look at debt funds solely on the basis of their investment horizon and accordingly narrow down on the right scheme," says one debt fund manager.

 

Pointers to keep in mind when selecting a debt fund


Duration: First see if the fund manager's mandate is what suits you. You cannot have an investment horizon of 45 days and invest in a long-term debt fund (see: What risks does your fund manager take?).

 

Returns: Is the fund generating higher returns than its peers? Check the portfolio. It could well be that the fund manager is compromising on quality of paper to generate those extra returns (see: What risks does your fund manager take?).

 

Size: In the debt market, on an average, the minimum lot size is around Rs 5 crore while the minimum ticket size in a primary issue could be Rs 50 crore. Hence a very small fund is at a distinct disadvantage. On the other hand, a large-sized fund may be in a position to strike better deals but if faced with huge redemptions, the market might not have adequate depth to bail it out. Avoid the two extremes.

 

Costs: Expenses have a significant impact on the relative performance of debt funds. It's important to see that your debt fund does not have the highest expense ratio while delivering just about average or below-average returns. The spread of returns, especially in big short-term fund categories, is very narrow. A small difference in return can significantly change the ranking. For example, among institutional ultra short term funds, 1-year returns of around 20 of the 49 funds is stacked in a range of 0.40 per cent.

 

Experts Opinion

 

Nilesh Shah
Deputy MD, ICICI Prudential MF

It's virtually impossible to take a 10- or 15-year call on interest rates. Even a 5-year view is difficult. There are numerous variables which constantly change. Over the long run, interest rates will be dependent on the demand and supply of money. If India remains a supply constrained economy and inflation stays high, then it would require nominal interest rates to also remain high. On the other hand, if we become pro-active on supply side, we may not have too much of an issue with inflation, especially in a world which is deflationary in nature. In the short term, we think interest rates will remain in a reasonable range. They won't go dramatically up or down.

 

Suresh Soni
CEO, Deutsche MF

In the aftermath of the global crisis of 2008, interest rates in the country have been brought down to artificially low levels. We have not seen the reverse repo or overnight rate this low in a long time. So over the next 1-2 years, the RBI is likely to normalise the short term policy rates - repo and reverse repo. If that happens then it is expected to lead to a rise in the short term rates in the market. However the current crisis in Europe could potentially lead to a slowdown in the pace of rate hikes.

 

Bond markets tend to be forward looking. Interest rate actions of the central bank are anticipated by market players and they adjust their portfolios accordingly. So we may have a situation over the next 12-18 months where the short-term rates rise but yields on long-term bonds, say the 10-year government paper, may not rise much because the central bank moves would have been factored in by the market.

 

Today 10-year G-Sec is trading at around 7.5 per cent, which is at a significant higher differential over the short-term policy rates, as compared to the historical averages. So the current 10-year G-Sec yield has already factored in a large part of expected future rate hikes. Hence, I do not see a corresponding move in G-Sec yields, when the policy rates are raised.

 

Match scheme to invest horizon

Categories

 

Average Maturity of Portfolio

 

Investor's time frame

 

Liquid

 

Securities with maturity of maximum 91 days

 

Money on call. With virtually no downside risk.

 

Ultra-short term

 

Average maturity over the last 18 months is less than a year, but which are not liquid funds

 

1 to 3 months

 

Short term (including Gilt schemes)

 

Average maturity over the last 18 months is between 1 year and 4.5 years

 

Upto one year at least

 

Short term (including Gilt schemes)

 

Average maturity varies as per declared objective

 

Should be used opportunistically as per the interest-rate scenario to optimise returns

 

 

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