WF: How do you see the government borrowings program playing out and what could be its impact on bond markets?

Lakshmi Iyer: As far as the budget and the fiscal deficit numbers are concerned, I think it is broadly in line with expectations. The deficit number expected was about 5.5% of the GDP - and that is what the Budget has indicated.

So, 345,000 crores of net borrowing is broadly in line with the consensus expectations. But the matter of concern here is that independently this number is going to be a fairly big one, given the fact that you are going to have very limited part from the RBI in terms of OMO's - that is buy back of securities etc., and also the fact that there is not much of MSS to be unwound. In this kind of a scenario, if you are talking about a growth period where credit off take is going to be significantly better than last year, I think this will definitely put some pressure on the term structure - that is the yield curve and ultimately you could see the benchmark 10 year which is trading under 8% right now to comfortably go beyond the 8% region. My sense is that you could see around 8.25% to 8.50% for the 10 year, especially given the fact that the borrowing program is not going to be any different than what it was last year in terms of being front loaded.

WF: On the shorter end of the curve, what are your expectations ?

Lakshmi Iyer: Shorter end is predominantly going to be driven by what the benchmark action that is going to be from the RBI front, obviously the bulk of the discounting had happened. Today, what is happening is that overnight is at 3.25% and your 3 month yields are close to 6%. I would say that this steepness is not warranted and you will definitely see some kind of flattening happening as you cross March. Because March is typically a tight period for money market as a whole.

Come April, we expect RBI to hike rates by 50 basis points on both the benchmark repo and reverse repo. So you could be at 3.75% on overnight rates and perhaps 4.5% to 5% on 3 month rates. But the challenge here will be that beyond 3 months again the curve might little bit start widening because of this new mutual fund regulation. Effective 1st July, anything above 3 months is going to be mark-to-market. So the predominant interest may be in the less than 3 months segment from the MF industry - which is a big driver of yields. I would say there is a case for 3 months and beyond segment steepening.

WF: In this scenario, should investors with 3 to 6 month money look at short term funds or stay in ultra short term funds?

Lakshmi Iyer: I would say that if the horizon is going to be 3 months then FMPs which cater to 3 months - given the present 3 month yield curve - is fairly attractive. It makes more sense to lock into 3 months FMP kind of products. But yes, if the horizon is about 6 months - it would definitely make sense to consider short term bond funds.

WF: Investors with 1 year + funds : should they go in for 13 month FMPs with indexation benefits or should they look at duration funds?

Lakshmi Iyer: See today, yields available in the 12 to 18 months segment are anywhere between 6.75% to 7.5% - so that is the broad range you are to expect if you were to try and lock into to an FMP of this particular maturity. So if that is the kind of yields one is wanting or aspiring over the period, and with indexation benefits, I think FMP is the clear cut answer. However, I also believe that at around 8.25% or so, it definitely makes a lot of sense for investors to consider allocation to gilt and bond funds with a one year plus horizon.

Even in 2009, when we saw the 10 year yields rise by 2% to 2.5%, gilt and bond funds didn't lose money - Kotak Gilt and Kotak Bond funds for example have delivered flattish to marginal returns. Now, from 8% or 8.25%, I really don't think you are going to see that kind of linear upward movement on the benchmark. I would say for those investors who understand market risk and the embedded volatility which comes with debt markets, I think it definitely makes sense to allocate the money to duration funds as you see the benchmark yields go up.

WF: If one is looking at benchmarks yields going up to 8.25, 8.5 levels is that an expectation that they will remain waited there or do you think there is a softening for one reason of the other, on the other side of the 8.5.

Lakshmi Iyer: 2010 this year you are going to see more of a trading market rather than a trending market. So it is not that there is going to be one linear upward movements in interest rates you know you will have technical related buying at every level people or investors perceive that there is value over here to lend to the government of India to lending to a non government entity because on a risk reward basis, are higher levels maybe 8.25 levels may be better off lending to government of India you know sovereign trade risk understanding. I would say that you will have these kinds of opportunities to capture and it is not going to be a one way street and therefore I think fund houses will seek to capitalize on that and provide alpha to investors. But as I said the horizon to rate -rate, you know the point those 2009 also pickup 5% on 10 year is currently 8% still the investors who invested on that day and lost money. So you have invested in such a low yield and still ofcourse opportunity cost is there no doubt bit I am saying the incidence of capital loss unfortunately in fixed income is not there.

WF: The other way of looking at this is that if I were to have a return expectation of around 6.75% to 7% on a 13 month FMP - we understand that these are not indicative returns given by an AMC - but purely on the basis of the prevailing yields in the market, then I would look at a duration fund only if my expected return would be significantly higher than 7% - say around 8% or above. Is this a reasonable expectation from a duration fund over a 12 month horizon?

Lakshmi Iyer: I think 2010 is going to be more of a trading market than a trending market. Its not going to be a one way street and therefore I think fund houses will seek to capitalize on trading ranges to provide alpha to investors.

I would say that in duration funds, over the next 12 months, about 75% to 80% of returns will come from accruals and the balance obviously to be made from capital gains, because you will have to capture those 5 -10 basis moves multiple times in a year to be able to add some more alpha to the carry.

My sense is the probability of earning around 8% on a duration fund over the next 1 year is quite high. Lets do the arithmetic : if you are running a 5 year duration for example and if you capture 10 basis point rally 5 times in a year, you have added 2.5% on to a net carry of about 6% on the portfolio. So that itself sums up to about 8.5 %. So I would say that there is a reasonable probability of being able to acquire that desired 8% to 9% kind of return, if you come in at a higher yield - at around 8.25% levels.