The Hindu Business Line : `Income funds will outperform floating rate funds'

The head of the fixed income funds of Deutsche Asset Management, Mr. Suresh Soni, has an impressive track record as a debt fund manager in India spanning over many years. In the initial years, Mr. Soni was associated with Sundaram Bond Saver and later with Pioneer ITI Income Builder Account. Business Line spoke to him recently about debt mutual funds.

Excerpts from the interview:

What is your approach to managing money?

We have been focussing on a top-down approach to interest rate forecasting. We track the macro-economic environment and the policy changes that are taking place not only here but around the globe. That gives you the direction of interest rates in the near- as well as the medium-term. That, however, does not lead to portfolio construction. Portfolio construction is also based on a bottom-up feel of the market dynamics.

The macro numbers may be telling you that interest rates may harden because inflation is going up, but you probably have to change your conclusion because of liquidity that has flooded into the system. You need to have a blend of both approaches. Based on that you have to decide where you want to position yourself in the near- and medium-term. Having done that, what should come into the portfolio is decided based on relative value of securities.

Having structured the portfolio, you keep on re-evaluating it all the time just to see that you are sitting on the right points on the yield curve, from maturities ranging from one to 25 years, and you are sitting in the right credit spectrum, ranging from gilts to AA or BBB, depending on what is permitted.

What are the factors that now impinge on the outlook for interest rates?

The economy is growing today like never before. We see the growth momentum continuing for the December and March quarter. Credit numbers are picking up too. That clearly tells us that, over a period, credit pick up can lead to a problem on the liquidity side.

The other part is inflation, which has been rising recently. Inflation will remain high in the next couple of weeks after which it looks like the base effect starts kicking in. There could be a perceptible fall in inflation from about 6 per cent to the 4.5-5 per cent band. But core inflation has, indeed, gone up from about the 3 per cent levels about 18 months back to an average level of about 5 per cent now. So, both credit demand and inflation suggests that there is limited scope for interest rates to fall now. On the liquidity side, the RBI is by and large committed to maintaining a reasonable amount of liquidity. Even after the credit pick up recently, liquidity in the system has stayed good. I do not see any pressure on the liquidity side in the next three-six months.

The easing of the ECB restrictions also helps that. The problem with liquidity is more likely in the second half of the year, after September or thereabouts, if the economy continues to be in good shape and credit demand continues. As of now we are seeing demand for working capital. Six months hence, it could be investment demand.

A Maruti or Telco or Tisco cannot continue to operate at current capacity levels and will have to expand capacities. That is when the credit demand will pick up. That is when I will start getting concerned about interest rates going up.

How much can it go up, if interest rates do go up? How much would yields on government securities go up?

It is difficult to forecast how much interest rates will go up. My guess is that in a market, which has been sitting comfortable and easy for a long time, the reversal could be significant. You could have a reasonable amount of hardening.

Could it be about 2 percentage points?

No. I will not go that far. It will be lower than the number that you are talking about. The yield on government securities and interest rates are too different things. There need not be a one to one correlation between interest rate movements and changes in yields of government securities. Government security yields are determined by the surplus funds parked by banks. If the perception about interest rates or inflation changes, people will shun government securities to a certain degree.

Why is this view not reflected in your portfolio construction? You are still largely invested in government securities...

That is because we are comfortable in the near-term. We have concerns over the medium-term. But different developments keep happening all the time. The opening up of the ECB changes my assumption regarding the amount of money that will come in from overseas. But we are mindful of the risks that this market can throw up.

The policy of the RBI is also important. The RBI maintained a soft interest rate bias for almost six years in an effort to kick-start the economy. The economy has benefited and has responded to the rate cuts. Now it looks like the RBI will want the interest rate to stay comfortable so that the growth momentum is not lost. The policy focus is now probably on maintaining the low interest rate environment.

So will the RBI be successful in maintaining the low rate environment?

If you started noticing, 2003 stands a little apart from the earlier years. From 1997 to 2002, government security yields have been falling sharply more than the credit cost of the economy. That was the case for almost six years. In 2003, for the first time, government security yields fell by about 1 percentage point but housing loan rates fell by 1.5-2 percentage points. Auto loans rates crashed by 2-3 percentage points. Now, the RBI appears to be focusing on bringing down the cost of credit to the consumer and not so much to the Government any more. The RBI will prefer that lending rates stay soft going forward.

If Government securities will under perform corporate securities going forward, can we expect mutual funds to invest more in lower rated corporate securities?

Mutual funds have generally invested in papers rated AA or better. They have generally taken only interest rate risk but not credit risk so far. Maybe the time has now come to start looking at that. Going forward, there will be a willingness on the part of mutual funds to look at lower rated securities.

But you have reduced exposure to corporate securities in the last few months...

That is more a technical move. We expect the credit spread between corporate securities and government securities to widen in the next two months. Corporate issues came to a virtual halt in the last few months because of confusion over listing norms. All those issues will hit the market in the next few months. Quite a few of them are bound by the financial year. The banks are also lining up their bond offers. The supply will rise at a point of time when appetite from mutual funds is typically low. Banks are also not likely to be big buyers given the capital adequacy norms for them. This could lead to widening of the spreads. That is the near-term view. That is not a fundamental view. But you need to have both a fundamental and near-term view. Hopefully, we should be able to buy these bonds at more attractive prices beyond March.

You have outlined a strategy for your dynamic bond fund? Is that not what you are expected to do in a normal bond fund? Is there a need for dynamic bond fund?

We felt the need for a product that played the interest rate environment more aggressively. In an income fund, the average portfolio maturity may go up to about seven years. In a dynamic bond fund, it might go up to 11 years. On a bearish day, the maturity of the income fund can drop to four years while in the case of the dynamic bond fund it can drop to one year. So, the bandwidth is slightly wider.

Floating rate funds have done well in the last 3 months. Do you think investors should load up on floating rate funds now?

In an interest rate environment that has been volatile in the past three months, floating rate fund has delivered better returns. Now, going forward, floating rate funds will not make sense as the core portfolio of an investor.

It is more of a parking alternative or for hedging. The core portfolio should comprise of short maturities and income funds. The money that is purely short-term in nature can go into floating rate funds or short-term funds. Medium-term money is generally advised to come into short maturities.

Even if interest rates remain volatile do you think the income fund would be able to outperform the floating rate fund over a longer time horizon?

I would certainly think so. Over a period, the fund that buys longer-term securities will out perform a fund that buys short-term securities. An income fund is a long-term product, but a managed product at that compared to a passive investment of locking your money.

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