Investment advisors have, for over the past one-and-a-half years, been asking their clients to invest in short-term funds with a maturity of around six months to a year. Long-term income funds and gilt funds have been a strict no in their scheme of things. As the central bank readies to meet on September 16 to review its monetary policy, the expectation is that it will hike the rates again. There is also the hope that this will be the last of the rate hikes in the current cycle.
If that is the case, investors should be asking if they should start investing in medium- and long-term income funds — the main beneficiaries of a pause or cut in interest rates — with a maturity of three years and above. Typically, a pause or cut in interest rates would benefit longer-duration bond funds since they are more sensitive to interest rate movements. They benefit most from the softening of bond yields.
However, it is not easy to predict the interest rate cycle or take a call on RBI policies.
The RBI can change its policy stance quite swiftly. For example, up to October 2008, the RBI was hiking rates to combat inflation, which was in double digit territory then. However, the financial crisis set in, and the central bank slashed key policy rates by as much as 4% within a matter of few months.
The central bank will most likely hike interest rates by 25 basis points, before deciding its next course of action. Most fund managers believe that the banking regulator is likely to pause after that. Rising interest rates lower growth, which the central bank does not want. The GDP grew 7.7% for the first quarter of FY12, compared with 7.8% in the fourth quarter of FY11.
In short, there is consensus that the central bank may hike rates by 25 basis points at least once more, either in September when it meets or in October. And that could be the last hike for some time.
Interest rates may not fall immediately. That is likely to happen over the next one year. Fund managers have already started making their moves in anticipation of a pause in rate hikes. Some debt fund managers have started adjusting their portfolios and have increased the average maturity period of their portfolios from the March 2011 levels.
Will Interest Rates Fall?
The answer will depend on two factors: the rate of inflation and the level of fiscal deficit. Inflation figures have eased marginally to 9.22% in July from 9.44% in June. It is, however, not a comfortable level for the government, which is targeting to bring it down to 7% by March 2012. And it is still not clear which way it will blow. Sure, there is good news on the global front. Brent crude oil prices have moderated to about $110 per barrel after touching a high of $125 per barrel in the recent past. With QE2 coming to an end, and an imminent slowdown in the US likely, commodity prices, too, have started showing signs of cooling off.
However, there is bad news at home. More than the global factors, local factors are more of a worry now. High food and vegetable prices are a concern as food inflation has crossed the 10% mark again to stand at 10.05% for the week ended August 20. However, a good monsoon may soften the blow. Global uncertainty will not let commodity prices to spike, while a good monsoon will help contain inflation.
Another cause of concern is the country's fiscal deficit. Simply put, fiscal deficit is the gap between the government's earnings and expenditure. As per a report by IDFC Securities, the food security bill will increase the subsidy burden by . 30,000 crore, while the excess fuel subsidy on account of the higher oil prices would account for another . 40,000 crore. With the capital markets in the doldrums, it is not clear how the government will meet its disinvestment target of . 40,000 crore this year.
The economy is likely to grow at a slower pace as compared to the previous year. This could raise the possibility of higher borrowings on account of lower tax revenues, thereby putting pressure on interest rates.
Interest rates may go up if the government chooses to borrow by issuing bonds.
How Much To Invest In Long-Term Funds?
We recommend aggressive investors to allocate 40-50% of their portfolio in income funds and gilt funds with a 3-4 year maturity. However, the advice comes with a rider. If your time frame is less than a year, short term funds and FMPs should still dominate your portfolio.
Short-term funds come first in the pecking order, followed by FMPs and then income funds. As per Value Research, an independent mutual fund tracking firm, the short-term fund universe has given around 7.45% in the last one year, compared with 6.93% of the income fund category.
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