The Hindu Business Line : RBI has a tough task on hand

Kolkata April 1 With the stock market returns being uncertain, it would make sense to invest in debt funds, argues Mr Devendra Negvi, Fund Manager and Head - Fixed Income, Quantum Mutual Fund.

How would the fixed-income market shape up in 2007-08?

The new fiscal may see a moderation in the economic growth rate and a slowdown of credit off-take in sectors such as retail and real estate. This may help interest rates to stabilise. The higher deposit rates have narrowed down the incremental credit deposit spread.

If inflation tapers off, the fixed income markets in 2007-08 may generate reasonable returns of about 8-10 per cent.

What are the most important issues a fixed-income investor should consider this fiscal?

Remember, income or gilt funds do carry market risk. As interest rates fall (or rise), the returns from such funds rise (or fall). Such market risk can be quantified by the duration of the fund. Higher the duration, higher is the risk in a rising interest rate scenario and vice versa.

Income funds, unlike gilt funds, also carry a credit (default) risk in papers in which they invest. Investors should put their money in funds that have better credit profile. The liquidity of the portfolio is worth noting since some segments of the fixed-income markets are illiquid.

How do you expect interest rates to behave? What would impact rates in the next few months?

At the start of new year, we expect the short rates to moderate from the higher levels in March. GOI spending, foreign capital flows and inflation will be the crucial issues in determining the liquidity in the system and interest rate movements. RBI has a tough task on hand - achieving the "impossible trinity" - namely, a partly managed exchange rate, an independent monetary policy and a liberalised capital account. Global cues in form of US rates are of paramount importance.

How do you expect the central bank to behave?

RBI will continue to tighten the liquidity till inflation (6.5 per cent), money supply (22.1 per cent year-on-year) and credit growth (29.8 per cent) remain above its targeted levels. In 2006-07 (till January 2007), RBI has already bought USD worth Rs 56,543 crore, which it will keep on sterilising. The base effect on inflation in the current year is expected to be stronger.

The supply of GOI bonds for 2007-08, which commences in April, is relatively moderate and demand will be reasonable from banks and financial institutions, if RBI doesn't cut the SLR. The first quarter may see a relatively flat yield curve.

Is there scope in taking exposure to longer term debt funds? Isn't the market too focused on shorter term products?

Yes. An interest rate cycle usually lasts for around 3-4 years. It is important to invest in longer term debt funds when interest rates are closer to their cyclical peaks. A slowdown in the economy, higher foreign inflows, falling inflation etc are some of the major issues for an intended long term debt funds exposure.

Investors usually focus on shorter end of the yield curve during the last quarter of the financial year, since the rates are higher when the liquidity is tight, on back of advance tax outflows and other year-end considerations.

Shorter term products usually do not carry any duration risk. This makes them attractive vis-à-vis bank deposits due to the tax benefits on dividends declared. FMPs of more than 12 months get indexation benefits.

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