The persistent weakness in the Indian rupee since the last couple of months finally initiated an action from the Reserve Bank of India (RBI) whereby they hiked short-term rates on Monday (July 15, 2013) late evening with immediate effect. The central bank increased the Marginal Standing Facility (MSF) and Bank Rate by 200 basis points (bps) placing them at 10.25% each, thereby resulting in a spread of 300 bps between the aforesaid short-term rates and repo rate (which is 7.25% at present).

The central bank also capped the amount which banks can borrow from the overnight markets to Rs 75,000 crore.

The rationale behind the move...
Primarily, such an action has been initiated as a measure to control depreciating rupee. With the rise in interest rates, the RBI intends to make investing in Indian debt markets attractive amid a scenario where even in the U.S. 10-Yr. treasury yields have inched-up (on account of the U.S. economy depicting signs of vigour and after statement from the U.S. Federal Reserve earlier on winding down of bond-buying programme) and attracting many to invest there instead.

But would this really lure foreign investors to invest in Indian debt markets?
Well, prima facie PersonalFN is of the view that such a measure while may bring some respite and control the rupee in the short-term, it may not have a very positively lasting impact on the rupee movement unless the macro-economic fundamentals improve.Thus you see, the longer maturity bond yields after adjusting for currency hedging may not yield much returns driving foreign investors away from India debt markets. It is noteworthy that Foreign Institutional Investors on a year-to-date basis, thus far (i.e. as on July 15, 2013) have already been net sellers to the tune of Rs 18,235 crore.

So, what would be the impact of the move?
As a result of hike in short-term rates by RBI, the yields of shorter maturity debt papers [such as Certificate of Deposits (CDs) and Commercial Papers (CPs)] would go up by about 25 - 50 bps in the next few weeks.

One could also expect home loans and auto loans to be expensive as a result, which in turn may turn out to be a dampener for the Indian economy since growth may further slowdown due to higher borrowing cost.

Such a move also seems to hint of reversal in interest rate cycle gradually until weakness in rupee and pressure on Current Account Deficit (CAD) reduces. And if the central bank indeed increases policy rates in its forthcoming monetary policy review, banks may also raise deposit rates.

What strategy should debt investors should adopt?
PersonalFN is of the view that, it would be best to refrain investing in longer maturity debt papers given the aforesaid move from RBI. It would be prudent to prefer shorter maturity debt papers. In case if one wishes to take exposure to longer duration instruments or debt mutual fund schemes holding longer maturity papers (as permitted by their high risk appetite), PersonalFN recommends that you do so by investing in dynamic bond funds, since there would always be intermediate interest rate risk involved.

In the current scenario while investing in debt instrument, 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. If you as an investor have a short to medium term investment horizon (of 1 to 2 years), you may allocate a part of your investment to short-term income funds, provided that you are willing to take some interest rate risk. Avoid investing in G-sec funds, as they may see high volatility and may not be an ideal instrument to yield fruitful returns. Fixed Maturity Plans (FMPs) of 3 months to 1 year period can also be considered as an option to bank FDs only if you are willing to hold it till maturity. Alternatively you can also invest in 1 year Fixed Deposits (FDs). At present banks are offering interest on 1 year FDs in the range of 7.00% - 8.75% p.a.

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