Debt fund investors will have to live in a hostile debt environment for at least two more quarters. Unless liquidity is of paramount importance, it is advisable to stay invested in government bonds for the medium term. Cash funds may be considered for the short-term.

The markets are never prepared. Rather never prepared enough for any negative news. Last week, when the RBI governor Y V Reddy announced a 25 basis-point hike in repo rates in the bank's monetary policy for the second half of fiscal 2005, the markets did not take kindly to it even though the hike was not way beyond expectations.

Reason: the central bank's decision to raise repo rates has come in the wake of inflationary concerns and the Governor did not quite rule out the possibility of further increases in rates in case inflationary pressure persists. Strong credit-offtake also poses a threat to rates.

After the policy announcement on Tuesday, yields on 10-year benchmark government paper shot up from 6.68 per cent to 6.82 per cent. For the rest of the week, bond yields continued to inch up with the 10-year benchmark touching a high of 7 per cent on Friday. The mood on Bond Street is cautious with a strong bearish undercurrent.

All this, of course, is bad news for debt funds. On October 26 alone, the day when the credit policy was announced, the medium term bond fund category lost an average 0.22 per cent, according to data provided by Value Research which tracks mutual funds.

This was thrice as much as the category's gains of 0.08 per cent for the year till October 25, the day before the announcement came (see table: Repo effect).

Repo Effect
Nav change (%)
Oct25-26	Y-T Oct 25	Y-T Oct 26
Gilt med/long term      -0.44	-0.96	-1.38
Debt med/long term    -0.22	-0.08	-0.15
Gilt short term            -0.03	-1.66	-1.62
Debt short term          -0.03	-3.03	-3.00
Debt ultra short term   -0.01	-3.51	-3.52
Debt floating rate        -0.01	-3.65	-3.66
Source: Valueresearchonline.com

Gilts funds fared even worse. The category lost 0.44 per cent on the same day. Short-term debt and gilt funds were also hit, albeit marginally (0.03 per cent).

Not just that, dynamic bond funds, which are free to keep their asset allocation flexible between cash and bonds, depending on the market mood, also lost in value as many fund managers were caught on the wrong foot.

Cash/liquid funds and floating rate funds, however, remained relatively stable. Debt funds continued to slip for the rest of the week as the sentiment remained weak. For the first time in the history of debt funds, the returns are in negative territory for a full year (see table: Shades of red).

Why the pessimism?

For the current fiscal, the RBI increased its inflationary forecast from 5 per cent to 6.5 per cent while reducing the GDP growth forecast from 6.5-7 per cent to 6-6.5 per cent, citing deficient monsoon and uncertain oil prices.

Besides, the policy stance was changed from 'adequate liquidity' to 'appropriate liquidity'. Reddy also made it clear that the RBI would pursue an interest rate environment that is conducive to price stability and maintaining growth momentum. At the same time, the central bank will consider measures in a calibrated manner to respond to evolving circumstances to stabilise inflationary expectations.

The RBI also acknowledged that the current inflation levels are lower than potential, as higher international prices have not been reflected locally. This alignment as well as the pass-through effect should add 2.2 per cent to WPI (wholesale price index), according to the RBI estimates.

Besides, there are uncertainties regarding commodity prices. All of this, obviously, hinted at the possibility of further tightening of rates if inflationary pressures persist. Add worries about the government's borrowing programme at a time when the credit demand is strong (non-farm credit growth is likely to be higher at 19 per cent), and the picture looks dim.

"Reading between the lines of the policy, coupled with our in-house research view on commodities, we see risks of another hike in the repo rate in the medium term. We expect the market to reflect this uncertainty and discount a bearish outlook on gilt yields, especially in the short term," said a fixed-income strategy report released by Merrill Lynch last week.

And then, there are technical factors, which are weighing on the markets. Given the heightened uncertainties, risk appetite is low among traders. The demand for government paper is already low from the banking system. Mutual funds have little leeway to indulge heavily in the markets as they are having to face large-scale redemptions.

"There appear to be few events that could alter the medium-term view significantly," the Merrill Lynch report said. Perhaps, Merrill Lynch was not expecting the central bank in China to raise interest rates so soon.

The silver lining

The decision by the Chinese central bank to raise one-year lending rate by 27 basis points in its efforts to cool the overheated economy has come as a relief to debt markets. There are also noises that oil prices could ease after the US presidential elections. And then, the base effect could itself keep inflation levels under check.

Says Rajiv Anand, chief investment officer, Standard Chartered Mutual Fund: "The base effect itself should make sure that inflation could come down to 4 per cent or thereabouts by February-March."

Besides, if US interest rates are any pointer to the direction in local rates, there may not be too much downside. Compared to a 40 basis-point spread between US treasury rates and 10-year GoI around May, the spreads are up to 200 basis points now.

"In the past, this kind of divergence has never sustained for long," says Nilesh Shah, chief investment officer of Prudential ICICI Mutual Fund. Says Dhawal Dalal, debt fund manager, DSP Merrill Lynch Mutual Fund: "The widening spreads between US and Indian treasury yields suggest that the 10-year paper may be oversold."

Anand believes that the medium term top for the benchmark paper could be around 7 per cent for the next three-six months. According to him, 2005 could well turn out to be a good year for debt markets.

"If the Chinese economy slows down, not only would commodity prices come off but it could lead to a slowdown in a number of other economies and set the stage for easy interest rates," Anand explains.

A majority of market participants, however, feels that the worst may not yet to be over. Higher commodity and oil prices could continue to exert pressure on prices for at least a quarter. "The bad news is reflected only partly in the prices. The next two quarters would be challenging," says Shah.

Dalal maintains a neutral to positive stance over the medium-term. He says the fair value for the 10-year paper could be around 6.60 per cent. "If the auctions lined up for next month go through smoothly, the market will be more confident," he adds.

In the short-term, however, bearishness persists. "We expect the markets to remain weak in November and would like to buy into that weakness," says Anand.

The Merrill Lynch report said: "We expect to see an improvement in sentiment around Q4 FY05 and look to deferring any increase in long duration assets to later when clear signs emerge." At the moment, fund managers are cautious in their approach, running portfolios with a maturity of one-four years in medium-term bond funds.

Where to put your money

This may not be a good time to put your money in debt funds at all. Clearly, medium- and long-term debt and gilt funds are completely avoidable. For investors who are not too keen on liquidity, the RBI savings bonds should be the best option.

From a one-year perspective, the best alternative is fixed maturity plans because they effectively give better tax-adjusted returns while having the same characteristics as fixed deposits. FMPs are also available for short-time frames. The other alternative could be short-term debt funds.

"Short-term plans clearly comes out to be the best pure debt investment for medium to long term, as the expected returns are stable and higher for investments over six-months," says Suman Horo, chief manager, product research, Kotak Mahindra Bank.

In fact, even for investors who are willing to hold on for an year or more, short-term debt funds today are better than medium-term bond funds as expenses are relatively lower in short-term funds. While the yield to maturity is about 6.75 per cent on an average for debt funds, the same for short-term plans is about 6 per cent.

However, the higher expense ratio of 1.7-1.9 per cent for bond funds compared to less than 0.8-1 per cent for short-term plans will ensure that returns will effectively be higher in the latter (see table).

How sensitive are debt funds
	Average portfolio	Modified	Yield to	Expense	No.of days to recover losses  if yield increases by				Expected 1-yr return if yield increases by (trading gains not included)
	Maturity (yr)	duration (yr)	maturity (%)	ratio (%)	25 bps	50 bps	75 bps	100 bps	0 bps	25 bps	50 bps	75 bps	100 bps
Gilt funds	5.5	3.75	6.5	1.15	61	117	168	216	5.35	4.66	3.98	3.29	2.6
Bond Funds	4.5	3.25	6.75	1.7	56	107	153	196	5.05	4.49	3.93	3.36	2.8
Short-term plans	1.5	1.25	6	1	22	41	60	76	5	4.94	4.88	4.81	4.75
MIPs*	1.25	1	1	1.7	21	40	56	72	6.28	6.28	6.28	6.28	6.28
MIPs**	1.25	1	1	1.7	21	40	56	72	0.28	0.28	0.28	0.28	0.28
Floating rate funds	0.75	0.7	5.3	1	0	0	0	0	4.3	4.3	4.3	4.3	4.3
Liquid funds	0.19	0.18	5	1	0	0	0	0	4	4	4	4	4
* MIPs' debt portfolio profile is given, assuming MIPs with 80 per cent debt and 20 per cent equity. For calculating MIPs' one-year returns, equity returns are assumed to be positive 15 per cent per annum ** For calculating MIPs' one-year returns, equity returns are assumed to be negative 15 per cent per annum Floating rate funds and liquid funds have near minimal or nil mark-to-market investments; so they are not impacted by interest rate changes Source: Kotak Mahindra Bank

For investors looking for more ambitious returns, monthly income plans which invest about 20 per cent of their investment in equities could be a good option. Dynamic bond funds, which seek to maximise returns for investors by actively managing duration, may be avoidable as they have failed to perform till now.

Dynamic bond funds failed to arrest the fall in NAVs as most fund managers were caught on the wrong foot by the RBI governor. In many cases, the fall in the NAV of dynamic funds was as much as in vanila bond funds.

Data sourced from Mutualfundsindia shows that the biggest fund in the category, Standard Chartered's Dynamic Bond Fund, fell 0.34 per cent between October 25 and 27, as against a fall of 0.23 per cent in its Medium Term Plan and 0.47 per cent in its Super Saver Income Fund. The fund, which was managed like a liquid fund since inception, hiked its portfolio maturity just ahead of the credit policy.

"We took a view on the market based on the strength of the rupee, not anticipating the sudden surge in oil prices," says Rajiv Anand, chief investment officer, Standard Chartered Mutual Fund.

The fund's portfolio was running at an average maturity of 4.4 years when the policy announcement came. Same was the case with many of the other dynamic bond funds. Birla's recently launched dynamic fund was down 0.50 per cent in two days.

Similarly, Deutsche was hard hit with NAV falling 0.59 per cent. Kotak's Dynamic Fund and Prudential ICICI's FlexFlexible Income Plan were down 0.23 and 0.36 per cent. Tata Dynamic Bond Fund and ABN Amro's Flexi Debt Fund were the least affected with marginal losses of 0.09 per cent and 0.009 per cent respectively.

Among debt-oriented funds, liquid funds and floating-rate funds continue to be the safest. "Returns under liquid funds would improve after the increase in repo rate. Though FRFs would take some time to show higher returns as higher returns would be reflected only after their reset period," says Horo.

Besides, floaters have seen tremendous inflows in the recent months. Market participants say that in the absence of adequate floating-rate instruments, which are actively traded in the market, fund managers are forced to buy into interest rates swaps.

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