Bond markets are likely to remain steady even if interest rates are hiked. It could be a good time to start investing in short-term debt schemes.

If you have been steadily putting money into fixed-income mutual fund schemes, you must be pleased with yourself. After a year of poor returns in FY05, income schemes suddenly earned you more in the last six months.

And the last one week has been particularly good. For instance, long-term gilt schemes turned in 8 per cent annualised compared with less than 4 per cent for the full year. Income funds returned 5 per cent plus as a category; the number for a year was 4.5 per cent.

Floaters and liquids would have earned you 5-5.5 per cent over the last one year, while short-term plans would have offered slightly more.

That is more than most banks have been giving you especially on a post-tax basis. Of course, the star performers have been monthly income plans (MIPs) -- with a 20-25 per cent equity kicker. With the stock markets on a roll, they have produced returns of 36 per cent for the last week and 12 per cent for the year.

But as they say, one swallow does not a summer make. What can you expect from the bond markets in the near term? After a tumultuous 2004 in which the yield on the 10-year benchmark swung between 5 per cent and 7.5 per cent, the bond markets have been steady in 2005.

Benign inflation, currently at 3.08 per cent, and adequate liquidity have resulted in yields remaining stable - the 10-year benchmark is trading in a narrow range between 6.9 and 7.10 per cent.

Despite oil prices ruling at $55-$60 per barrel, headline inflation has not gone up because a good part of the increase has not been passed on to consumers.

Some of the liquidity in the system has been diverted to banks to fund growth while oil companies, too, have been borrowers, but despite this, there is ample money in the system.

Possibly because it was comfortable with the way the currency was moving and because it did not want to disturb the growth momentum, the central bank opted for a status quo and did not raise the reverse repos rate in July. The markets were surprised but took it in their stride.

But with oil hitting $70 dollars a barrel, it's difficult to see the government not passing on some of the burden to consumers. An interest rate hike seems unavoidable given the possibility of higher headline inflation even though recent inflationary trends in the economy have been unambiguously benign.

Elections in key states notwithstanding, the markets believe that both petrol and diesel prices could be hiked by about Rs 2 per litre. If that is so, it could translate into a rise in inflation of between 50 and 70 basis points. However, fund managers are not unduly worried about its impact on inflation.

Observes A Balasubramanian, head, business development, Birla Mutual Fund, "Inflation is not a major worry because if petrol price increases would increase inflation by about 50 basis point, while the cascading impact could increase it by another 30-40 per basis points. However, most companies are focusing on volume growth, given competitive pressures and that can act as a cushion."

According to Rahul Goswami, senior fund manager, Prudential ICICI, the base effect for inflation is favourable till November, after which it could inch up to a range of 5-5.5 per cent.

While that is manageable, US interest rates (set by the US Federal Reserve at which it lends to banks) could also influence a rate hike in the October credit policy. The Fed has raised rates to 3.5 per cent and expectations are that it would be at 4 per cent by the year-end.

And therefore, like Goswami, this time round, too, most fund managers are once again betting on a rate hike. Not a large one but a 25 basis points hike in the reverse repos rate - the rate at which the central bank borrows from banks.

Says Binay Chandgothia, head, fixed income, Principal PNB AMC, "Apart from other factors, the RBI may also consider a rate hike because with industrial growth rate is high, an element of asset inflation is being built up.

"Adds Dhawal Dalal, head, fixed income, DSP Merill Lynch, "The market is expecting a 25 basis points hike in the reverse repo rate in the October credit policy and if that happens, the yields could go up slightly and the 10-year benchmark would probably go up to around 7.20 per cent from 7.10 now."

Suresh Soni, head, fixed income, Deutsche AMC, believes that there's a fifty-fifty chance of a rate hike. "We don't think inflation by itself warrants a hike because inflation would probably not cross 5 per cent, but with oil at these levels, it is possible that the central bank would go ahead with a small hike," he says.

Dalal believes that the markets are delicately poised and therefore investors should, for the time being, stay invested in liquids and floaters where the risk of capital erosion is the least.

Says he, "Regardless of the ample liquidity and the benign inflation, it is prudent to wait for a while before putting money into income plans." However, as Chandgothia points out, even if there is a rate hike, those looking to invest with a one-year time horizon, should not worry because current inflation is low.

"The market may not have fully priced in a 25 basis points hike, but even if there is a hike the 10-year yield should trade between 7.10 and 7.25."

Fund managers believe that while the core holding could be in liquids and floaters, investors could start putting money into other schemes.

Says Goswami, "While there is a need to be cautious, we are suggesting to investors that they make staggered investments in income schemes and gilts schemes, while keeping most of the money in liquid plans."

Others, too, believe that the markets are comfortable and that there's no need to be too defensive.

Adds Soni, "Investors can afford to take a medium-term perspective. While short-term plans (STPs) can form the core of the portfolio, they could make some allocation to income funds and medium-term bond funds. In fact, long-term bond funds have given a return of over 6 per cent annualised in the last six months."

And Chandgothia believes that returns for the next year too could be upwards 6 per cent. Should you hold on for a full year, you could also get the benefit of indexation. That means your tax outgo could be lower, enhancing your returns.

Short -term Plans (STPs) have on an average delivered returns of over 5 per cent in the last one year and have managed to outperform income and gilt funds on a risk-adjusted basis.

In fact, over the past three months, these schemes have returned around than 6 per cent. Taking advantage of the steepness of the yield curve at the shorter end, fund managers have been buying into  higher yielding, longer maturity corporate paper, in a bid to improve the returns.

And they're not finding it difficult to get corporate paper of AAA or AA+ quality at reasonable yields. While most of the paper would have a maturity of less than two years, fund managers are also parking some of the funds to slightly longer term paper.

That's because currently the spread between one year corporate paper and two- or three-year paper is large. For example, the yield on one-year paper is around 5.85-5.9 per cent while the yield on two-year paper is 6.3-6.4 per cent. For three years, it's as much as 6.8 per cent. The reason for this is the expectation that interest rates will rise.

Says K Rajagopal, chief investment officer, Reliance Mutual, "Sometimes we also invest in three year paper, but we make sure that the maturity of the portfolio does not go above 1.25 years. The one-three years maturities are delivering the best value and if rates go up we will drop maturities."

STP portfolios have seen a relatively low volatility because fund managers have generally opted to stay away from government securities, given the possibility of interest rates going up.

Observes Rajagopal, "Since most of the portfolios have a very low component of government securities, the volatility, has been contained and the schemes have done consistently better than liquid and floaters."

The volatility of most of the portfolios has in fact, reduced, according to a study done by ICICI Bank [Get Quote], and the average volatility of STPs in its universe has fallen from a peak of 0.4 per cent in January 2005, to 0.31 per cent in June.

With the equities market booming, monthly income plans have also turned in splendid returns. Fund managers believe that equities could easily deliver returns of 10-12 per cent per annum which would boost the overall returns of MIPs.

Another reason fund managers are feeling more confident about recommending investments, albeit in small doses, is because they don't also feel that the rupee would depreciate enough to impact the bond markets.

Says Dalal, "The rupee could depreciate marginally against the dollar over the medium term." Adds Balasubramanian, "Only if the rupee depreciated by more than 5 per cent would it impact bond markets adversely."

Also, while India Millennium Bonds (IMBs) are due to be redeemed in December - an outflow of around Rs 6.5 billion dollars - capital flows from FIIs have been strong. And while higher interest rates overseas could have some impact on domestic liquidity, it would be marginal.