Funds that have high credit exposure at the short end of the curve are best avoided as the credit yield curve is likely to see a parallel shift upwards from current levels
Interest rates are on an upward trend and while every level might look better than the previous level, locking on to rates is not a wise decision as the next level will look even better. Investors should invest in liquid funds till such time interest rates stabilize and that time is still far away. Short term FMPs (Fixed Maturity Plans) of three months and less offer a quasi floating rate alternative. Funds that have high credit exposure at the short end of the curve are best avoided as the credit yield curve is likely to see a parallel shift upwards from current levels. Short term funds and others of its ilk will underperform significantly in the current interest rate environment. Government bonds will outperform corporate bonds in the coming days but will nevertheless face an upward shift in the curve. High yield funds that take credit exposure to high risk corporate are best left alone as the credit environment is likely to deteriorate given the current macro economic environment. Unfortunately, your investor will have to live with the fact that inflation is higher than fixed income returns leading to an erosion of value of investments.
The RBI has signalled a further tightening of policy rates in their January 2011 third quarter monetary policy review. The RBI raised repo rates by 0.25% to 6.5% and reverse repo rate by 0.25% to 5.5%. The system is borrowing around Rs 100,000 crore from the RBI on a daily basis at the repo rate of 6.5% and with continued liquidity tightness the cost of overnight borrowing will go up. The tight liquidity conditions have inverted the corporate bond yield curve with one year rates at 9.9%, five year rates at 9.2% and ten year rates at 9.15%. The curve inversion will continue though there will be a parallel shift in the curve with yields moving higher across the curve. Continued liquidity tightness coupled with RBI tightening will force the shift in the curve.
The government will present the union budget for 2011-12 to the parliament at the end of February 2011. The budget will set the course for an upward shift in the government bond yield curve as the market frets on the absorption of next fiscal’s borrowing program. High bond supply in times of weak demand, high inflation and rising policy rates will push the yield curve higher. Bank demand for bonds is low in the face of slow deposit growth at 16.2% year on year and high credit growth at 23.5% year on year. Banks are forced to draw down on excess liquidity to fund credit leading to weak demand for government bonds. Inflation at 8.5% (WPI or Wholesale Price Index) and primary article inflation at 17% is forcing the RBI to continue policy tightening. Government bond yields at around 8.15% for the five and ten year bonds have still some way to go up in the face of the deteriorating interest rate factors.
Your investors in gilt funds will see losses as the gilt yield curve shifts upwards. The absolute levels of yields may look better than what it was one year back, but that in itself is not a reason for yields to stabilize or trend down. The factors driving yields are more important and those factors as mentioned earlier are highly interest rate negative.
Such periods of interest rate bearishness will see lower rated credits accessing the market with juicy yields. Promoters, non banking finance companies, real estate companies and other such low rated borrowers will offer yields at levels of 20% and higher. These come with very high risk of default especially at times when liquidity is tight, banks are cutting down lending and interest rates are moving up. Advise your investors to stay away from these.