WF: The 10 year gilt is hovering around the 8% levels - and causing some anxiety in the marketplace. Where do you see interest rates headed over the next 3-6 months?

Alok Singh: Yes, 8% is pyschologically a high number, but if you look from a broader perspective, the 10 year interest rate in our market had stayed something between 7.5% to 8.5% for most of the time over the last several years. The historical reference rates are still quite valid.

Inflation is now around 8% and some economists are talking of something like 9.5% by March end - though RBI itself is projecting it at 8.5% by March end. If you look at it from a historical perspective, interest rates have traded around 200 bps above the WPI. The present inflation rate is high largely because of food inflation - if you however look at manufacturing inflation, it is around 6% year on year. If we did not have the drought situation - a one off event, food inflation would not have been this high and overall inflation would have been closer to 5% - 6% levels. In that cntext, an 8% interest rate looks quite ok - around 200 bps above a "normalized" inflation level - which is in line with historical trends.

We have to bear in mind that RBI had changed its stands from accommodative to a more hawkish stance and we have a huge borrowing calendar to be subscribed. So all that is exerting pressure on interest rates. I think the 10 year gilt can move up to between 8% to 8.5%.

I think 8.5% should be the pivotal point, can temporarily overshoot that because normally markets have a tendency of going overboard.

There is some risk aversion which is getting created again in global economies - which can impact liquidity. Domestically, the 10 year gilt is mostly being supported by public sector buyers. If liquidity gets tightened and banks don't have that much of surplus because they are all already above their SLR levels, we could see some pressure on rates. These are typical situations which can cause temporary blips above the 8% - 8.5% range which I think is reasonable.

WF: We are also witnessing a lot of activity in the short end.

Alok Singh: Yes, because so far we had liquidity supporting it. Now clearly inflation is a worry and RBI's stance has changed. And with that, people are not that willing to lock in for a longer period anything more than 3-4 months. That's the reason if you look at the one year rates CD's, they are trading at over 6% - which earlier was around 5.5% - a move of 50 basis points. At the bottom, they were around 5% - 5.25% - in my view there is a potential for a further rise. This will also be a function of how much liquidity remains in the system.

WF: What are the signs you will look out for to determine pressure on liquidity - will it be a pick up in credit offtake or other external factors?

Alok Singh: What happens with credit offtake is that it goes out of the banking system but comes back with a multiplier effect. So, it actually increases M3 - which, after a lag, increases the liquidity in the system.

I am more worried about the portfolio flows - because outflows take out liquidity from the system - unlike a pickup in credit demand. Portfolios flows are a significant portion of the current liquidity - I think that is to be watched very closely.

The other issue is the commodity prices - especially the commodities that India imports - and how the costing of that goes up and its implications on the rupee. RBI is trying to maintain a fine balance between not being too loose nor too tight on liquidity.

WF: Should advisors start recommending duration funds now or should they wait for a further spike in the 10 year gilt yields before getting their clients to invest?

Alok singh: I think it is time for advisors to put their thoughts together and begin talking to clients about duration funds. I think somewhere between mid-March and end-March, you might see a pick up in rates - which may offer good entry points.

The point is that even if rates do peak in end March or April, they are unlikely to come off in a hurry. Though you may say that 8.5% is a good level to buy from a long term perspective, you should be able to hold it for something like 8-9 months because till the borrowing calendar gets completed, there will be pressure. It could be quiet volatile, but if you can stay invested for over 8-9 months, you should be able to make money.

WF: There is a lot of retail money coming into MIPs these days - and over 80% of this retail money is invested in this fairly volatile debt market. As a fund manager, how do you try to control volatility in such a retail product - where investors are not the well informed HNIs and treasurers?

Alok Singh: Honestly, there is no rocket science we have to manage this situation. The only thing that we can do is that the equity portion and the debt portion are managed just as you manage individual debt and equity funds - with the same amount of fundamentals put into it. The only advantage you have in MIPs is that you can swing the allocation based on the view of the market. If that is done well, it can drive your performance very significantly.

Individual stock selection on the equity side and the duration on the debt side will continue to play a big role but I think on the debt side of the MIP, the portfolio has to be structured in a way that it has to give some steady accrual. Ideally you should not be running a very high duration there. The duration should be somewhere closer to our short term income fund kind of a category - something like 2 - 2.5 years. Then the additional alpha should come from equity. The reason why I am saying so is that if the duration you run is very high on MIP and you have an equity component as well, you are exposing the portfolio to too much volatility, which the investor may not be prepared for.

That's how we manage our MIP product. It is an 80-20 product. We are currently some 18% invested in equity and the debt side is running a duration of around 2 years - with mostly corporate paper which gives a healthy accrual. 2 year corporate paper currently yields around 8%.