Debt Funds: On solid ground

Debt funds have always lent stability to a portfolio, especially in volatile times. They will continue to do so in the coming year. For a prognosis of the year ahead, it is imperative that we revisit the past events which have shaped the current markets.

The past two years have been eventful for the India economy, which witnessed a sharp V-shaped recovery after the tumultuous last quarter of 2008. The year 2009 was characterised by the huge fiscal and monetary stimulus provided by the government and the Reserve Bank of India (RBI) in consonance with the rest of the world. This was aimed at stimulating the economy after the financial market collapsed in 2008. In response to the huge fiscal deficit, the long-term yields went up and shortterm rates dropped due to the abundant liquidity.

Reacting to the economic recovery and rising inflation, the RBI started withdrawing the easy-money policy in February 2010. Till mid-December, the central bank had hiked the repo and reverse repo rates by 2 and 1.5 percentage points, respectively. (The repo rate, currently at 6.25 per cent, is the rate at which the RBI lends to banks and infuses liquidity into the system, while the reverse repo, currently at 5.25 per cent, is the rate at which it borrows from banks.) The cash reserve ratio, or the proportion of funds that banks have to deposit with the RBI, has been increased by 1 percentage point to 6 per cent.

With the RBI tightening its monetary policy, the repo rate has become the operational rate. In the past few weeks, banks have borrowed more than Rs 1 lakh crore from the repo window, which makes the liquidity situation worse than that witnessed in the aftermath of the Lehman Brothers' bankruptcy. As a result, the short-term rates have shot up, with one-year certificates of deposit rate at 9.5 per cent, up 2.5 percentage points in the past six months.

In the current scenario, short-term income funds make a compelling case for investment as they have the potential to deliver a return of 9-10 per cent over the next one year. The liquidity crunch may not persist for long as the government spending makes its way through the banking system. The RBI has said that its comfort zone for liquidity is in the range of 1 per cent (plus or minus) of the net demand and time liabilities. It has already set the ball rolling by conducting a couple of open market operations and more are expected to come. Short-term rates are already discounting a worst-case scenario.

For the long term, the yield curve should remain stable, with fiscal deficit numbers for the next year and inflation trajectory being the important variables to watch out for. There is uncertainty on the fiscal front as the revenues from the auction of spectrum and disinvestment will not be available in the next fiscal year. The uncertainty over subsidies continues to linger.

However, the increase in the limit of the foreign institutional investment in five-year bonds is a positive development. All these factors will make the yield curve more steep, with the short-term income funds performing well and the long-term funds remaining stable.

PUNEET PAL
Fund Manager, UTI Mutual Fund

WHAT 2011 HAS IN STORE FOR YOU

1. How 2011 will impact you 2. Buoyant market, bullish returns 3. A roller-coaster year ahead 4. Top stock picks for 2011 5. Tracking a positive theme 6. Retail investors should go global 7. Keep pace with changing times 8. Debt funds on solid ground 9. Make the best of uncertainty 10. All set for new, improved cover 11. 'New norms don't include incentives' 12. Invest in a house, cautiously 13. 'Teaser rates don't benefit anyone' 14. Supply crunch to push commodity prices