'Fixed maturity plans will offer opportunities to risk-averse investors in 2011'

Sujoy Das, head of fixed income at Religare Mutual Fund, expects the Reserve Bank of India (RBI) to hike interest rates again in the January monetary policy review. After that, he sees the central banking taking a longish pause and step in only if the wholesale price index (WPI) inflation shifts into a higher trajectory in the second half of 2011. In an interview with DNA, he talks about what’s in store in the year ahead. Excerpts:

How was the year for debt funds?
It was mixed. Funds with shorter duration outperformed the longer ones. The interplay of liquidity and inflation trajectory affected performance. The interest rates at the longer end were largely affected by the RBI’s stance around inflation and rising inflationary conditions. The yields at the shorter end moved higher due to a protracted period of liquidity deficit.

How does the year ahead look? Will it be another year of fixed maturity plans (FMPs)?
Next year, interest rates at the longer end will track inflation and the RBI’s stance around it, while short-term yields will react to the liquidity situation. Inflation is expected to gradually come down in the first half due to base effect. Hence, debt funds with moderate duration are expected to post superior risk-adjusted performance over the year. However, the duration of the debt funds plays a significant role in terms of fund selection for investors. The recent dynamics of interest rates is suggestive of much shorter cyclical pattern than in the past. FMPs will offer opportunities to risk-averse investors. However, we believe that over the year, investors with various degrees of risk should allocate certain exposure to interest rate products with various levels of duration.

The RBI will launch a new 10-year benchmark gilt soon. What is the outlook for it next year? Do you see it touching 9%?
The 10-year benchmark is trading at a yield that is higher than the long-term average. Since interest rate movement is largely cyclical in nature and is mean-reverting, we believe the gilt is trading at a level that is in a buy zone. The outlook for gilts over 2011 is positive. The risk-return trade-off is tilted in favour of gilts over the year. Over the next couple of quarters we expect the 10 year gilt to trade at finer levels and move closer to the long-term average of 7.50%. This probably will get largely buoyed by the positive sentiment following any decline in WPI inflation due to base effect. Looking at the long-term average of the benchmark yield, we believe that there is a higher probability of it coming closer than moving away. The inflation trajectory over the first six months will play a very important role in determining market sentiment. The risks to inflation upside due to base effect and food inflation could rise in the second half.

Liquidity crunch is forcing banks to redeem their investments in mutual funds. Do you see liquidity improving next year?
The liquidity crisis within the banking system is expected to improve over the next quarter following government’s conclusion of its expenditure programme. Liquidity could continue to be in negative territory but might improve from the current situation. We believe the liquidity situation over the next quarter to be better than the current quarter. But the asset -liability mismatch in the banking system would continue for a while more and improve with better household savings rate.

What do you think the RBI will do at its monetary policy review in late January?
We do expect the RBI to hike rates and there might be a longish pause thereafter. It could once again step in if the inflation trajectory shifts higher in the second half of the year. The risks to inflation and growth continue within the system and the RBI would like to balance it out over the year. The upside risk to inflation continues following elevated food inflation and international crude oil prices.

The investment objective of your latest offering, the Religare Medium Term Bond Fund, says that investments will be made in medium term debt and money market instruments. Can you through some more light on that? Who are the target investors?
The Religare Medium Term Bond Fund is a new product offering from the house and is appropriate for investors with over six months investment horizon with a moderate risk appetite. The fund intends to build a high-quality portfolio of corporate debt and money market securities with maturities of one to two years. There are four investment strategies - namely, build a portfolio with high accrual, stay biased for holding assets until maturity, capture positive valuation changes due to the roll-down of residual maturities and capture positive valuation changes due to changes in the shape of the yield curve. The current shape and position of the yield curve proffers several opportunities to investors depending on their investment horizon. The yields on several maturities along the curve are trading at attractive levels, which are higher by 150 basis points from the previous three to four-year average. Moreover, the liquidity deficit situation has led to short term yields rising persistently over the last two quarters; the near months have risen by over 300 basis points. Hence, the current shape of the yield curve is suggestive of a very high accrual apart from higher probability of capital appreciation due to the roll-down effect over the next two quarters.

What suggestions you would like to give retail investors of debt funds?
They should select funds depending on their investment horizon. The credit risk within the funds is also important to understand. The duration of the fund should be in line with his investment horizon.