FUND FLAVOUR
(December 2009)

The see sawing penchant for debt funds…

The share of debt funds in the Indian mutual funds universe has risen from 69 per cent in December 2008 to 77 per cent in February 2009 and fallen to 66 per cent in September 2009 indicating a shift in investor preference for and against debt funds due to the change in market dynamics. In the past 6-9 months, stock markets have risen by over 100 per cent. Even interest rates, which were at double digits during October 2008, have slipped considerably. However, with both CPI & WPI indices on the rise, there are indications that interest rates will not fall further. In its credit policy review recently, RBI has given some signals of the possibility of hardening of interest rates due to increased inflation. It has increased SLR & has taken back the facility given to banks for liquidity needs of mutual funds and NBFCs at the height of the global financial crisis.

For investors in debt mutual funds, it is imperative to select that category which suits their risk taking ability and time horizon.

Gilt Funds
Double edged sword!

For most part of 2008, gilts were habitual non-performers, or chalked up nothing spectacular. Not much was expected of them either. This changed only when the Reserve Bank of India (RBI) got into the active mode to combat the liquidity crisis with a series of rapid cuts in the repo rate between October and December 2008. This had a dramatic influence on gilts. With a cut of 2.5 per cent in repo rate and a cut of 3.5 per cent in Cash Reserve Ratio, gilt funds' returns just shot through the roof. This over-performance was mainly due to the 20.69 per cent returns registered during the last quarter of 2008, in particular, the 12.43 per cent gain logged from just the month of December 2008. These fabulous gains got investors excited. Gilts looked the obvious means to recoup losses made in equity. Gilt funds' assets almost doubled from Rs 2500 crore in November 2008 to Rs 4800 crore at the end of February 2009. However, things changed again for gilt funds as falling inflation numbers and increasing uncertainty in the economy forced the RBI to announce a cut in the repo rate by 50 bps in March 2009. But to the dismay of many, the yields refused to budge in response. The gains expected by investors were nowhere to be seen. The reason for this was the on-going borrowing program of the government. 2009 has not been a very exciting year for gilts as the category is down by 7.16 per cent.

Fixed Maturity Plans
Like Phoenix from the ashes…

FMPs witnessed a purple patch in the 2006-07 period when bond yields were on the rise. Fund houses launched a host of FMPs, investment advisors did their bit to promote the cause of FMPs as ‘assured return’ investments and investors gleefully lapped up the FMPs on offer. The fact that FMPs are market-linked investment avenues and are subject to risks like credit risk, the actual yield not matching the indicative yield, among others were all but ignored. However, these risks were brought to the fore by changing market conditions. Factors like a slowdown in the economy and the ensuing liquidity crunch meant that the creditworthiness of some companies whose debt instruments FMPs had invested in came under the scanner. Then there were instances of some fund houses making investments in illiquid instruments in a bid to clock higher growth. In some cases, longer tenured instruments found place in FMPs with a shorter maturity profile. Such investment strategies were tested when liquidity dried up and investors (in a panic mode) rushed to redeem their FMPs, forcing fund houses to make distress sales. This in turn had a telling effect on the performance of FMPs, which further contributed to the panic.

FMPs that controlled more than a fifth (22%) of the Indian mutual fund industry's assets in September 2008 lost out (17% in December 2008 and 13% in February 2009) to a series of regulatory changes that make them a tough sell for fund houses. Ban on pre-maturity withdrawals and mandatory listing raised cost for the low margin FMPs and made them less liquid. The regulator also instructed fund houses to stop declaring indicative yields on such funds, a key factor that lured large corporates to FMPs, removing the predictable nature of returns. But now, fund managers in India are scrambling to launch fixed maturity plans on hopes of the prospect of better returns than liquid funds. Falling short-term rates and regulatory changes have dented returns on liquid funds, which park funds in instruments up to 91 days, helping boost demand for FMPs which invest in medium-term and long-term papers as well. Liquid, liquid plus (fund) returns which were earlier probably in the range of 6-7 percent have now fallen to... 4-5 percent. An analysis of the performance of 100 top FMPs during the past year shows that at least 30 per cent of these funds have given returns in the range of 15-33 per cent. By comparison, banks were giving 10.5 per cent interest for one-year maturity a year ago. Such high returns were possible because several of these FMPs invested in equity-linked debentures issued by foreign banks in September-October 2008.

Income Funds

In the red…

Overall, 2009 has not been the year to remember for this category. It is still languishing in the red with a return of -0.05 per cent. 27 funds out of 56 funds under-performed the category with eight funds falling into red. The longer-term variant of debt funds continued providing positive returns with a return of 0.27 per cent. But compared to October 2009 it was down by 28 basis points in November 2009.

Floating rate funds
Head floating just above water….

From April, 2009 onwards the Long-Term Floating Rate funds are dominating their shorter-term variants. Long-term Floating Rate funds in comparison to their Short-Term counterparts continued to post better returns in November 2009. The latter posted 0.33 per cent returns in comparison to 0.48 per cent posted by Long-Term Floating Rate funds.

Liquid funds

A temporary parking slot….

Unless, you want a temporary parking option for your money, liquid funds would not be a good investment option at this point. Gilt funds have returned an average of 5.4 per cent over the last five years, while the best among them returned over 10 per cent. From January 2009 till date liquid funds have fallen by 8 per cent on an average.

… not to see saw asset allocation

Stick to a fixed allocation between equity and debt investments for your portfolio. Within each portion, allocate a certain percentage to aggressive and passive options, depending on your risk profile. Do not switch from equity to debt funds in an effort to “chase” returns, as that may prompt you to move into each asset at the wrong time. Right now, you can invest a portion of your debt fund portfolio in gilt funds. They may deliver reasonable gains, but of a much lower order over the next one year. But FMPs have risen to the occasion. This essentially means that a portfolio with a judicious mix of gilt and FMPs may hold higher potential for returns over a one-year plus period, rather than pure gilt funds.

Keep an eye on indicators that can be precursors to a fall in interest rates - a slowdown in GDP growth, rising inflation, a decline in IIP (Index of Industrial Production) and expectations of a fall in corporate earnings, to name a few. Broadly speaking, a situation when interest rates have peaked and a downturn seems imminent, would be an opportune time to invest in debt funds. Of course, you must understand that to make the most of your debt (gilt and other long term) fund investments, being invested for the long haul (to cover an interest rate cycle) is important.