Should you stay away from income funds now?   Jul 29, 2013

In the recent past the volatility in the Indian debt market has sent shivers down the spin of many investors - especially those who perceive investing in debt markets to be safe. While some mutual fund houses are viewing this as an opportunity to increase allocation towards duration funds, even pink papers and business channels by offering diverse views are leaving many investors confused.

But at PersonalFN we believe it is imperative for investors to take count of the situation and then take a prudent investment decision.

You see, in order to contain the languishing Indian rupee, the RBI increased short-term rates and took measures to lap the excess liquidity in the system.

First, in mid-July 2013 (on July 15, 2013) it raised the Marginal Standing Facility (MSF) and Bank Rate by 200 basis points (bps) placing them at 10.25% each. Also it limited LAF borrowing by a bank to 1.0 per cent of the Net Demand and Time Liabilities (NDTL) of the banking system (capping it at Rs 75,000 crore). But recognising that it was exhibiting a limited relief to rupee and to check undue speculation adding to undue volatility, the RBI took the second move (on July 23, 2013) by limiting access to LAF for each individual bank to 0.5% of its own NDTL (thereby capping it as Rs 37,000 crore). Moreover, banks were asked to maintain Cash Reserve Ratio (CRR) of 99% (of 4% i.e. about 3.96%) with effect from July 27, 2013 on daily basis as against the earlier minimum requirement of 70%. So it has turned out to be a double whammy for the banks also impacting the Indian bond markets.

The impact on the Indian rupee

(Data as on July28, 2013)
(Source: ACE MF, PersonalFN Research)

While the aforesaid move by RBI has brought in some relief (of 1.4%) to the rupee, until what extend it continues yet remains to be seen. It is noteworthy that since beginning this fiscal year, the rupee has fallen 8.1%. On July 8, 2013 it hit a lifetime low of Rs 61.21 against the U.S. dollar forcing the Reserve Bank of India (RBI) to resort to the aforementioned steps.

What about the impact on Indian bond markets?
Well, the India bond markets - especially duration funds and gilt funds, have witnessed rather a violent fall in their NAVs thereby impacting their returns as a result of ascending yields. While foreign investors are enticed with higher yields, it has not gone too well on the returns of debt mutual fund schemes - especially of duration and gilt funds.

The table above reveals, that in the income funds category those holding longer maturity papers have taken more hit since RBI's move (to contain the falling rupee), while the short-term income funds have been less battered. Likewise gilt funds too have had their share of detrimental impact in both short-term as well as long-term category.

You see, the reason why we have cited herein the performance of gilt funds is that, even income funds do invest in Government securities (G-secs) and thus if an income fund is holding G-secs in its portfolio, the returns can be impacted.

And how are they likely to perform in the future?
Well going forward too, longer maturity papers would remain under pressure until the RBI maintains the aforesaid stance as a measure to contain the rupee. In RBI's 1st quarter review of monetary policy 2013-14 (scheduled on July 30, 2013) too, the Indian rupee would take the centre stage. In fact when the RBI first took measures to contain the rupee (on July 15, 2013), in its press release it enunciated that they would continue to closely monitor the markets, the liquidity situation and the macroeconomic developments and will take such other measures as may be necessary, consistent with the growth-inflation dynamics and macroeconomic stability.

Thus it is expected that in the 1st quarter review of monetary policy 2013-14 (scheduled on July 30, 2013), the RBI may keep rates unchanged. The chances of increasing the repo rate or even Cash Reserve Ratio (CRR) appear bleak after the recent stance taken to defend the rupee. Although, WPI inflation has mellowed to a 3-year low of 4.86%, the threat remains from country's Current Account Deficit (CAD)which in the last fiscal year touched a record high of 4.5% (at U.S. $87.8 billion) - much over the central bank's comfort level of 2.5% of GDP. Moreover now weakness in rupee is adding to the worry over CAD and is also infusing risk of imported inflation. But the central bank would refrain from increasing policy rates immediately as that may stifle growth. Having said that, reversal in interest rate cycle gradually cannot be ruled outif the macroeconomic situation takes a turn for the worse.Thus in intermediate, income funds and gilt funds - especially the ones holding longer maturity papers would continue to remain under pressure and witness high volatility.

What should investors do?
PersonalFN is of the view that, it would be best to refrain from having exposure to longer maturity debt papers given the aforesaid backdrop. Hence avoid investing in income funds and even gilt funds. If permitted by your time horizon and risk appetite if you still want to invest in long-term debt funds, it would be wise to take exposure via dynamic bond funds (as enabled by their mandate they hold debt instruments across maturities). But PersonalFN thinks that given the aforementioned interest scenario and macroeconomic variables thereto, one should not hold more than 20% of their debt portfolio in longer tenure funds.

In the present scenario, it would be ideal to invest in shorter duration instruments vide debt mutual fund schemes having shorter maturity profile. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month, or liquid plus funds for next 3 to 6 months horizon.

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