RBI has signalled a change in its monetary policy.  If you go back in history, RBI does this typically in 3 phases :

In their latest policy statement, they have clearly mentioned that they are watching the liquidity situation closely and that they are worried about rising inflation. A lot of RBI’s actions in the near term are likely to be motivated by inflation concerns.

Inflationary pressures are more supply side constraints

Separately, the RBI Governor has stated that most of the inflationary pressures are supply side constraints – especially food inflation and that in such a situation, there is not much that RBI can do.  A small uptick in inflation may not therefore result in too many policy actions – but if inflation begins to rise uncomfortably, you should expect aggressive RBI measures.

Expect 10 year to inch up to 8% levels in 3-6 months

If you look at signals in the bond market, a 10 year gilt yield of around 7.25% to 7.5% can easily arrest an inflation of 5% to 6%. I think the market is discounting that kind of an inflation expectation and also perhaps one or even two rate hikes of 25 bps each. Having said that, as and when RBI announces its first rate hike, you can expect markets to swing to that announcement, as the market will then start discounting possibly 3-4 future rates hikes. This can result in the 10 year gilt breach the 8% levels. So, that’s what one can possibly expect in terms of levels over the next 3-6 months.

Duration funds can still beat liquid fund returns even as rates inch higher

The upmove from hereon is expected to be 50bps to 75bps – which is not a very large move.  Let me give you an example that demonstrates why this is not such a big worry.  If you have a portfolio with a 6 year duration and you are holding only 10 year bonds, a 75bps movement over the next 6 months will result in a loss in your portfolio to the extent of about Rs. 4.50. Against this, a coupon yield of 7.5% p.a. over this six months will give you an accrual of Rs. 3.75.  Your net loss will be Rs. 0.75 in the worst case.  Now, that’s not a large gap for an active fund manager to bridge through trading in this 6 month period.

If you compare this with what you earn in a liquid fund – which is 3% to 4% annualised, a fund manager managing a duration fund will need to cross a hurdle of around 2% plus a worst case loss of 75bps.  That’s not too tall an order for a sensible fund manager to beat.

Duration fund investors should remain invested

I would therefore recommend that investors who have invested in bond funds should continue to stay invested.  We have seen over the last year, a 250 bps rise in yields.  What we are foreseeing ahead is probably another 50bps to 75bps.  Investors who have lived through the pain in 2009, should stay invested as the bulk of the rise is behind us, not ahead of us.

We also know that the borrowing calendar will be lighter in the last quarter.  We are also seeing decent demand for the supply that’s coming from the Government.  Insurance companies will collect large amounts of money in the last quarter – which should further bolster the demand side of the equation.

I therefore feel that there is no reason for an investor in a duration fund, who has stayed invested through 2009, to exit now.  He should stay invested.

Money market rates can move up appreciably

The money market is a different situation.  This is a purely liquidity driven market.  The scenario will change here.  For example, the daily put-call market – which is around Rs. 40000 – 50000 crores – is set to dry up following RBI’s recent measures.  This means that those corporates will have to come into the market for their borrowings – which can easily push up rates by 50bps.

Remain in ultra short term, avoid MTM exposure

If you look at the past year, 10 year bond yields have moved up by 250 bps while money market yields have only moved up by 50 bps. And that is only because of the excess liquidity.  Looking ahead, I believe that we should expect significant upmoves in the money market rates. I would therefore recommend investors with a shorter time horizon to consider ultra short term funds without any mark-to-market components.  I would not advice fresh investments in short term funds which have an MTM component, at present.