Investing? Short-term debt funds are best!

With the benchmark 10-year gilt yield touching a two-year high of 7.33 per cent in intra-day trades, are the bond markets bottoming out ?

Some fund managers are of the view that yields are unlikely to climb much further, given that the spread between the repo rate and the 10-year bond is now at 250 basis points.

Moreover, as Sameer Kulkarni, head of fixed income at Franklin Templeton AMC, points out that the spread between the repo and the 18-month paper is around 175 basis points.

"It's time for investors to start looking at short-term bond funds which typically have a maturity of 15-18 months," he says, adding that even long-term income schemes are beginning to look attractive.

K Ramanathan, fund manager, Birla Sun Life AMC, feels the current bond prices factor in most negatives such as high oil prices and inflation.

The current tight liquidity situation, fund managers say, should ease soon. Their reasoning: while the central bank does not want to stoke demand-pull inflation, neither would it want to stifle growth, so it would ensure enough liquidity in the system to keep rates under check.

The more cautious view, however, is that bond markets could rebound in the short term since the there is a chance inflation moving up in December, triggering another rate hike by the central bank.

That could see bond yields moving up. Says Rajiv Anand, head investment, Standard Chartered AMC, "the fear of a rate hike sometime in December does exist if inflation stays at around 7.5 per cent.

Adds Rajiv Shastri, head, fixed income, ABN Amro AMC, "While the rupee has been appreciating against the dollar, the quantum of appreciation is perhaps not enough. Moreover, if the rupee depreciates against other currencies, inflation could move up."

However despite the caution, Anand believes that it could be time to start monitoring the markets for short-term income schemes.

"We are closer to levels at which investors could start looking at slightly longer -term income schemes or even gilt schemes," he says, adding that it would probably be a good idea to wait out November and invest in December by which time the trend in oil prices would become clearer.

Observes Ramanathan, "Investors could take a look at short-term income fund schemes with maturity of around a year."

These schemes are invested in AAA or AA-plus corporate paper and investors could look at earning a net return of 5.5-5.75 per cent, which is higher than the rate earned on floaters or liquid schemes, which tend to offer rates in line with repos rate currently at 4.75 per cent.

Ramanathan believes that short-term bond schemes are preferable to gilt funds since the returns would be typically better as the former carry a credit risk. Moreover, since the average maturity of the portfolio is one year, the price risk is low if held for a year, he observes.

Adds Kulkarni, "While there may be some volatility in the interim, if the holding period is over a year, the price risk is minimised. For the more aggressive investor, Ramanathan recommends long-term income funds because he believes that portfolios have adjusted sufficiently so that the price risk now is substantially less.

Kulkarni too believes that long-term bond funds are beginning to look good. Shastri, however, feels that its probably better to stay with actively managed funds or dynamic funds for the time being. While some of these schemes have not done too well in the recent past, most of these portfolios have been realigned and have maturities of less than a year.

"There is potential to make money since fund managers can take advantage of the volatility in the market," he says, though cautioning that the risk too is high. For those of you who do not want to take a price risk stick with Fixed Maturity Plans.

The long-term scheme in this category (two and a half years) could earn you a net return of nearly six per cent given that there will be triple indexation benefits.

Moreover there is hardly any price risk if you hold the scheme till maturity. If, however, an investor wants to exit in between, funds charge a usurious exit charge of around 200 basis points. While debt funds have turned in disastrous returns over the past eight months or so, things might just be taking a turn for the better.

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