Strategise your investment in debt Mutual Funds, as interest rates peak out

Mar 18, 2011

The headline WPI Inflation has always been a fertile data point for the bond yields to pave their path. And for the Government and the central bank of our country (Reserve Bank of India), this data point has huge relevance when it comes to running a country or governing the banking and financial system.

At present the RBI as well as the Government - both are quite uncomfortable with the WPI inflation remaining above the 8.0% mark.

(Source: Office of Economic Advisor, PersonalFN Research)
Yes, WPI inflation has mellowed down after being in the double-digit terrain for the first four months of F.Y. 2010-11 (due to moderation in food prices). But now the rise in fuel prices is causing the WPI inflation to remain sticky.

In order to tame spiralling inflation, RBI so far has raised policy rates successively since March 2010. The repo rate has been thus far increased by 175 basis points while the reverse repo rate has been increased by 225 basis points. Moreover, the Cash Reserve Ratio (CRR) has also been increased by the central bank. It has been increased by 100 basis points, in order to control the earlier free flowing liquidity.

Policy rate tracker

	Increase / (Decrease) since March 2010	At present
Repo Rate	175 bps	6.50%
Reverse Repo Rate	225 bps	5.50%
Cash Reserve Ratio	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	unchanged	6.00%

(Source: RBI website, PersonalFN Research)
And now as inflation for February 2011 is at 8.31%, we once again expect the RBI to hike policy rates (both the repo rate as well as the reverse repo rate) by another 25 basis points in its fourth quarter mid-review of monetary policy scheduled on March 17, 2011. In our opinion, this rate hike would take interest rates near the peak and yields across the curve would rise which will in turn make bond prices look attractive.

We believe that RBI would not take any hawkish measures (while increasing policy rates), which could hurt the economic growth rate of our country. And reason for believing so is that, WPI inflation is likely to mellow further in the coming months (by May 2011) as the base effect fades away. Hence in that sense we believe further rate hikes aren't likely to be witnessed for at least some time, as the rise in interest cost would derail economic growth as borrowing cost would scale-up.

Liquidity too has remained tight since October 2010, and is expected to remain tight till end March 2011. Thus any increase in policy rates would cause a situation of "taps drying up". Hence, that again makes us believe that interest rates are peaking out.

Thus in such a scenario what should be your strategy while investing in debt mutual funds?
Well, now it's the time to gradually take exposure to pure income and Government securities funds, as interest rates are almost peaking out, making longer tenor papers look attractive. Longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has a longer investment horizon (of say 2 to 3 years).

Type of Fund	Time Horizon	Liquidity requirement
Liquid Funds	less than 3 months	Very High
Liquid Plus Funds	3 to 6 months	High
Floating Rate Funds	6 to 12 months	Medium
Short-term Income Funds	Strictly 1 year and above	Medium
Fixed Maturity Plans of 3 months to 15 months	Hold till maturity	Medium
Dynamic Bond / Flexi-Debt Funds	2 to 3 years	Low
Pure long-term Income Funds	3 to 5 years	Low
Government Securities Funds	3 to 10 years	Very Low

(Source: PersonalFN Research)
But while developing your strategy, you need to assess your liquidity need and what's your investment horizon.
So, say if you have a very short-term time horizon (of less than 3 months) and liquidity need is paramount, you would be better off investing in a liquid fund. Similarly, if you need funds after a period of 3 to 6 months, then liquid plus funds would be ideal for you.

Whereas, if you have a medium term investment horizon (of over 6 months), you may allocate your investments to floating rate funds.

Short term income funds should be held strictly with a 1 year time horizon. While one can even consider Fixed Maturity Plans (FMPs) of 3 months to 1 year (strictly hold till maturity) as the short term rates are attractive and these FMPs can generate attractive yield for the investors. 13 to 15 months FMPs can also be considered in order to gain attractive post tax returns by availing the double indexation benefits.

One should invest in longer duration funds, if the time horizon is of over 2 to 3 years. But you may witness some volatility in the near term as there is always an interest rate risk involved in the longer maturity instruments.

So be a prudent investor! Please do not trade on interest rates, but on the contrary play the interest rate cycles wisely by investing in debt mutual funds. This will help you generate safe and regular flow of income over the period of time.