Top Debt fund schemes to participate in falling interest rates environment

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  • 1. 1Mutual Fund Analysis November 05, 2012 Top Debt Fund schemes to participate in falling interest rates environment ! Background: The RBI’s stance on keeping key policy rates unchanged during its Second Quarter Review of Monetary Policy (on October 30, 2012) clearly signifies its apprehension over persisting higher inflation. The central bank indicated that it might ease policy in January to March, the final quarter of the fiscal year. While the RBI has kept rates on hold, it cut CRR by 25bps to 4.25% in order to inject more liquidity into the banking system. The cut in the CRR indicates central bank’s intention over further delaying in the expected OMOs. Notwithstanding. the fact that the move somehow disappointed the debt market, the market will now be expecting rate cut which would materialise in three to six months down the line (barring any uncertain events). This note deals with different categories of debt mutual fund schemes & how they could be impacted by the falling interest rates. Why interest rates can come down? Headline WPI inflation: According to the Governor of the RBI, headline WPI inflation has moderated from its peak of 10.9% in April 2010 to an average rate of 7.5% over the period January-August 2012 due to softening of prices of primary food articles. But from September there was a pick-up in the momentum of headline inflation owing to the increase in fuel prices and elevated price levels of non-food manufactured products. The inflation is now close to double digits level. It is to be noted that whereas the headline inflation is likely to peak in December due to higher global commodity prices, the improved winter crop could reduce the pressure on the food inflation side and in the fourth-quarter the supply-side pressure on inflation should also ease; hence providing some room for the RBI to cut rates. Systemic liquidity: Systemic liquidity conditions in the banking system witnessed crunch in the recent periods mainly on account of the build-up in the Government’s cash balances coupled with the seasonal increase in currency demand. This will pose risks to credit availability for productive purposes and could adversely affect overall investment. Despite the fact that the excess liquidity could aggravate inflation risks, cut in CRR rate and possible announcement of OMO purchases going forward will improve the liquidity condition in the system. Easing liquidity conditions will facilitate a turnaround in credit growth to productive sectors so as to support growth. Retail Research
  • 2. 2Mutual Fund Analysis contd… Growth Concerns: In the last one year period, Domestic economy has experienced a sharp slowdown in growth from 9.2% in Mar’11 quarter to 5.5% in June’12 quarter. In this second quarter review, GDP growth projection for 2012-13 was revised lower to 5.8% from earlier projection of 6.5% which was made during the time of First Quarter Review of Monetary Policy. Halted investment demand, moderation in consumption spending and continuing erosion in export competitiveness accompanied by weakening business and consumer confidence have muted the growth of the domestic economy. The recent policy announcements by the Government, a revival in investment. activity, which is key to stimulating growth has to be translated into effective action to convert sentiment into concrete investment decisions. Conclusion: Given the aforesaid conditions, one may assume that the RBI is likely to cut interest rates in Q4FY13 to boost growth and to support recent and ongoing Government efforts to stimulate the economy. However it is clear that the RBI will not aggressively start cutting rates till a moderation witnessed in inflation which comes within their comfort zone. So it is likely to say that there may be 25 - 50 bps rate cut till March 2013. When the RBI starts cutting rates the yield curve will likely steepen and shift lower, which benefit investors who own the long end of the yield curve. Meanwhile, given the easing liquidity conditions, the rates on short term money market instruments, which rallied and peaked to 11% level during the recent periods will fall close to 8% level. Given the current juncture of both demand supply dynamics and delayed rate easing, these are expected to favour medium to long term bonds. So we are of the opinion that investors with any kind of risk profile may buy or stay invested in short term funds for next two to three months. Investors with higher risk appetite may buy or shift into long duration funds gradually as the longer duration funds will get benefited once the interest rates starts to fall. How could long duration funds benefit? Duration of a fund is expressed in days, months or years which is used to calculate the average holding period of the assets in a debt scheme. Long duration funds means that these funds hold majorly longer maturity debt instruments in their portfolios. Retail Research
  • 3. 3Mutual Fund Analysis contd… Modified Duration - explained: Debt mutual funds gain in two ways - one from interest income and another from capital appreciation. Short term debt instruments whose maturity periods range from one day to one year mostly work on accrual basis to account for interest income. Long term debt instruments can get benefit in both ways from the bonds from interest income and capital appreciation. Capital appreciation arises from the bonds once the value of the bonds rise. This can be illustrated in the following example. Interest rates and prices of debt securities move in opposite directions. When interest rates rise, the prices of debt securities fall, and vice-versa. A company issues a debt. instrument in the market that pays its holder an interest rate of 8%. A few months later if the interest rates in the economy go up, there will be newer debt instruments that would offer a higher interest rate, say, 9%. These new instruments would fetch a higher return than the 8% interest instrument. The value (market price) of the older paper goes down. Likewise, when interest rate fall, the prices of debt securities rise. Hence, the longer duration funds will benefit and see an appreciation in their NAV values. Modified Duration of long term debt categories over periods (in Months) : 80 10 Yr G Sec Yield (RHS) Gilt LT Incom e Dynam ic Incom e 9.5 70 60 9.0 50 40 8.5 30 20 8.0 10 0 7.5 Jan-11 Jan-11 Feb-11 Mar-11 May-11 Jun-11 Jun-11 Jul-11 Oct-11 Nov-11 Dec-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jun-12 Jul-12 Oct-12 Sep-11 Sep-12 Apr-11 Aug-11 Apr-12 Aug-12 Retail Research
  • 4. 4Mutual Fund Analysis contd… Modified duration measures the change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. This formula is used to determine the effect that a 100-basis-point (one percentage) change in interest rates will have on the price of a bond. In other words, modified duration indicates the interest rate sensitivity of the fund. If you invest in a higher-duration fund, any interest rate cut will increase the value of your portfolio. Let us assume that the modified duration for the Income Fund is 5.37 years. If interest rates drop from 7% to 6.5%, the value of this. debt portfolio will rise by 5.37 x 0.50% = 2.685%. Similarly, when interest rates rise from 7% to 7.5%, the value of this debt portfolio will fall by 2.685%. The schemes which are from long duration debt mutual funds categories such as Gilt – Long Term, Income and Dynamic Income categories will perform well given in the scenario once the interest rates start to fall. Preferred Picks from Long Duration Debt fund categories: Note: Trailing Returns up to 1 year are absolute and over 1 year are CAGR. NAV/index values are as on November 02, 2012. Retail Research
  • 5. 5Mutual Fund Analysis contd… Gilt schemes – Long Term: Comparison of category Return, Bond Benchmarks & Modified Duration (Months): 115 C a t e go ry R e t urn ( LH S ) G S e c 5 Y r Y ie ld 9.6 C a t e go ry R e t urn ( LH S ) G S e c 10 Y r Y ie ld G S e c 15 Y r Y ie ld 115 M o dif ie d D ura t io n ( R H S ) 140 113 9.4 113 A vg M at (R H S) 120 111 9.2 111 109 9 100 109 107 8.8. 107 80 105 8.6 105 60 103 8.4 103 101 8.2 40 101 99 8 99 20 Jan-11 Feb-11 Mar-11 May-11 Jun-11 Jul-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Oct-12 Sep-11 Sep-12 Jan-11 Feb-11 Mar-11 May-11 Jun-11 Jul-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Oct-12 Apr-11 Aug-11 Apr-12 Aug-12 Sep-11 Sep-12 Apr-11 Aug-11 Apr-12 Aug-12 Modified duration of over all schemes in the Gilt – LT category witnessed a rise in the last two months period. This indicates the fund managers’ expectation of fall in interest rates in the near term. Average Modified Duration as per the latest month for the Gilt – LT category is shown at 74 months which is compared to 50 months, a year ago. The other factors such as improved liquid conditions in the banking system, the unveiling of road map to consolidate Fiscal Deficit by the Finance Minister, limited additional borrowing by the government, CRR cut and possible announcement of further OMO purchases by the RBI will favour the Gilt funds to capitalise on such opportunities. The 10 year benchmark yield eased close to 60 bps in the last six month period. Since, the Gilt Funds are higher risk higher return investments, only high risk appetite investors may invest in the top performing schemes from the category and stay invested for next 9 months to 15 months. Kotak Gilt - Invest and Birla Sunlife G Sec – LT are the preferred picks from the category. Retail Research
  • 6. 6Mutual Fund Analysis contd… Income Funds: Comparison among category Return, Bond Benchmarks & Modified Duration (Months): C at eg o r y R et ur n ( LHS) G Sec 10 Y r Y ield 118 C at eg o r y R et ur n ( LHS) 70 120 10.5 M o d if ied D ur at io n ( R HS) A A A 10 Y r C o r p Y i el d 116 118 A vg M at ( R HS) 60 10.0 114 116 50 114 112 9.5 112 110 40 110 9.0 108 30. 108 8.5 106 106 20 104 104 8.0 10 102 102 100 7.5 100 0 Nov-11 Jan-11 Jun-11 Jul-11 Jan-12 Jun-12 Jul-12 Feb-11 Mar-11 Apr-11 May-11 Aug-11 Sep-11 Oct-11 Dec-11 Feb-12 Mar-12 Apr-12 May-12 Aug-12 Sep-12 Oct-12 Nov-11 Jan-11 Jun-11 Jul-11 Jan-12 Jun-12 Jul-12 Feb-11 Mar-11 May-11 Aug-11 Sep-11 Dec-11 Feb-12 Mar-12 May-12 Aug-12 Sep-12 Apr-11 Oct-11 Apr-12 Oct-12 Most of Income funds witnessed an increase in their allocation into long term corporate bonds and gilt securities. The above charts clearly show the movement into the long duration papers. Average Modified Duration as per the latest data shows for the category at 40 months which is higher than 27 months last year. Majority of income funds in the category increased duration by increasing Gsec allocation as high yield provided opportunity to enter based on interest rate scenario; whereas the exposure to money market instruments and bonds was kept intact on expectation of liquidity situation getting more comfortable. It is the fact that Money market yields and corporate bonds yields across the tenor moved lower on easing liquidity. Income Funds are medium risk medium return investments. By virtue of being long duration, Income funds will generate higher returns (but not to the extent of Gilt funds) when interest rates fall as they capitalise mainly from capital gains. Hence medium risk appetite investors can invest in the top performing schemes from the category and stay invested for next 9 months to 15 months. Kotak Bond - Plan A and SBI Magnum Income are the preferred picks from the category. Retail Research
  • 7. 7Mutual Fund Analysis contd… Dynamic Income Funds: Comparison among category Return, Bond Benchmarks & Modified Duration (Months): Category Ret urn (LHS) AAA 1Y CORP 118 70 Category Return (LHS) 118 AAA 10Y CORP G Sec 10 Yr Yield 11.0 116 Modified Duration (RHS) 116 60 10.5 Avg Mat (RHS) 114 114 10.0 50 112 112 9.5 40 110 110. 9.0 108 108 30 8.5 106 106 20 104 8.0 104 102 7.5 10 102 100 7.0 100 0 Jan-11 Mar-11 May-11 Jul-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-11 Sep-12 Jan-11 Mar-11 May-11 Jul-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-11 Sep-12 In common, Dynamic Income funds are more sensitive compared to other debt categories to adapt to the situation depending on the environmental changes. Dynamic Income category has been in tandem with regular income category as far as Modified duration of the overall schemes are concerned. Dynamic Income Funds are low risk low return investments compared to regular income funds. Low to medium risk appetite investors can invest in the top performing schemes from the category and stay invested for next 9 months to 15 months. Reliance Dynamic Bond and SBI Dynamic Bond are the preferred picks from the category. Short Term Income Funds: Improved liquidity condition in the banking system ultimately eased the short term rates which resulted in generating lesser returns by the short term income funds compared to situation that was there in three months before. However, Short term funds can generate return close to 8.5% level over near term. JM Short Term Fund and Canara Robeco Short Term are the preferred picks from the Short Term Category. Retail Research
  • 8. 8Mutual Fund Analysis contd… Short Term Income Funds: Comparison among Return, Bond Benchmarks & Modified Duration (Months): Category Return (LHS) 12 18 118 118 AAA 1 CORP Y Category Return (LHS) 116 G Sec 1 Y 0 116 16 11 Avg M at (RHS) 114 CD 3 M 114 14 M odified Durat ion (RHS) 112 112 10 12. 110 110 108 9 108 10 106 106 8 104 8 104 6 102 102 100 7 100 4 Jan-11 Feb-11 Mar-11 May-11 Jun-11 Jul-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Oct-12 Sep-11 Sep-12 Jan-11 Feb-11 Mar-11 May-11 Jun-11 Jul-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Oct-12 Apr-11 Aug-11 Apr-12 Aug-12 Sep-11 Sep-12 Apr-11 Aug-11 Apr-12 Aug-12 Conclusion: Gil LT schemes are High risk high return investments which are suitable for high risk appetite investors. Income Funds are for medium risk medium return investments where medium risk investors can invest in such schemes while Dynamic Income schemes are low risk low return investments in which any investors can accumulate the units. Ideal investment time horizon is 9 to 15 months. Investors have to also be aware of the fact that exit loads which range upto 1.5% for exits on periods between 14 days and 1 year that are applicable on most debt schemes. Caveat: In case interest rates rise or remain steady instead of falling due to any reasons, then the strategy may not generate the desired results. However probability of this happening is low at this point. Retail Research
  • 9. 9Mutual Fund Analysis. Analyst: Dhuraivel Gunasekaran. HDFC Securities Limited, I Think Techno Campus, Bulding –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Phone (022) 30753400 Fax: (022) 30753435 Disclaimer: Mutual Fund investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared by HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in this document. This report is intended for non- Institutional Clients. Retail Research