Investors who chased super-normal returns on gilt and long-term debt funds by betting on them in January must now be a disappointed lot. Their returns are in the low single-digits and equity NAVs have zoomed! But the disappointment is prem ature and debt-fund investors who hold on for a year will still reap healthy returns, asserts Mr K. Ramanathan, Vice-President and Head-Fixed Income at ING Investment Management and one of the most experienced debt-fund managers in the country. In an interview with Business Line, he also spoke about whether credit has eased for India Inc. and whether the realty sector is back in the good books of fund managers.

Excerpts from the interview:

Fund houses did some hard-selling of debt and gilt funds in January. But returns so far have disappointed, with a few funds even logging negative returns for six months. Should investors stay on with long-term debt funds?

Investors in long-term income and gilt funds should typically have a horizon of one year. The investment horizon for an investor in short-term income funds should be about six months. If you stay invested for that period, you will get the returns that you were told. There will be intermittent volatility in this period, but that does not matter.

For example, given the current interest rates and the outlook, income funds should still give 7-9 per cent return over a one-year period, while short-term income funds should give around 6-7 per cent returns.

Liquid funds will give 3.5-4 per cent returns very soon. If that is the kind of return expectations that an investor has, then he should stick to income funds.

In evaluating debt funds, numbers are a mirage. There will be periods of time, one-month or two-months, where returns will be negative; primarily because of mark-to-market losses. In fixed income, unlike in equity, there is a big coupon component. Though the NAVs capture movements in bond prices, they do not reflect the coupon which is accruing every day. An investor who stays to maturity will get that in his return. The capital loss, if any, will be recovered by way of higher interest accruals if you hold on till maturity.

Further, the return sheets that you see report returns for one week, one month, three months, and so on. These returns are often annualised — that is, weekly returns are multiplied by 52 to get the number that you see!

If you see a negative 16 per cent for a month, it is not really a fall in the NAV. The actual decline may be only one-twelfth of that. You can look at the rolling returns every year daily for the past ten years. You will not find negative returns in income funds.

Another wrong perception is that gilt funds are more volatile than income funds. That is only because gilt funds usually maintain a longer duration.

If you take a gilt fund of five-year duration and an income fund with a similar duration, both will see a similar trend. The volatility in gilt funds is typically because they maintain a higher duration. While it is 3-6 years in income funds, the duration may be 5-8 years in gilt funds.

What category of funds would you then recommend to debt investors today?

We are strongly recommending short-term funds where the average maturity is 1.5-2 years. The choice has to be based on duration. Liquid funds have a current yield of only 4 per cent, whereas these funds have a higher current yield of 7-8 per cent. Investors can recoup any NAV volatility on the short- and long-term funds through coupon accruals. Duration management is something the fund managers will take care of.

The overnight rates are very low and so are the three-month, six-month rates. We believe that the RBI is almost at the end of the declining interest-rate cycle. Having said that, the rates will not go up over the next nine months or so, as the RBI will allow inflation and growth to move up before it acts.

That suggests that liquid funds are not going to give good returns. Short-term income funds invest in 1-3-year securities. This segment is peculiarly placed. The rates can’t go up too much because the selling pressure is very low. But the segment will still move with interest rates in the market, and that’s an opportunity for investors.

So you do not expect interest rates to go up sharply?

The policy rates won’t go up, but market rates may see a rise before coming down. The market theme today is the government borrowing programme.

The perception is that the Government will spend a lot on social programmes, and will not be mindful of the fiscal deficit. That’s why the market (the ten-year gilt) is not at 5 per cent (yield), but at 6 or 6.5 per cent. But in the Budget, we expect the Government to give a roadmap on fiscal deficit; where they will make a projection possibly for a reduced fiscal deficit by, say, 2013-14.

They can’t afford not to make this statement. When that comes in, as also the borrowing calendar for the year, interest rates will again pick up. That may prompt fund managers to increase the duration. Once the announcement is made, we expect there will be no negative news and the market will at least hold-on or rally after that.

Are RBI’s rate cuts reflecting in the borrowing costs of corporates?

Rates have come down to some extent, corporate bond spreads have come down, but bank lending rates (PLRs) have not fallen as much as the policy rates or the market rates. Let’s make a comparison.

The 9 per cent repo rate has come down to 4.25 per cent, which is a drop of 4.75 percentage point. Reliance Industries issued ten year paper at the peak at 11.5 per cent. Today, the same paper would be around 9-9.25 per cent — that is a fall of just 2.75 percentage points. So at least, 60 per cent of the rate cut of the RBI has been passed on to the market.

Looking at the PLRs, the public sector bank PLRs were around 12-12.75 per cent; they have now fallen only to 11 and 11.5 per cent. That’s only 25 per cent of the reduction. The markets have discounted at least 60 per cent of the reduction. So the market rates have come down, but the PLRs haven’t.

Realty companies, especially the small and mid-size ones are now looking to raise equity money through QIPs ( qualified institutional placements), but has the debt funding improved for them?

I don’t see any fund house taking any real-estate exposure in the debt space. In equity funds, they may take exposures because these are high beta stocks and there are signs of recovery.

The main constraint for a debt fund manager is liquidity. We might have comfort in a particular borrower. But if the paper is going to be illiquid, because I am open-ended at any point of time, I would need to be able to sell my portfolios. If I cannot find ready buyers, I may not like to take that exposure.

In liquid funds, given recent SEBI regulations, I have now a restriction of three months on maturity. In this segment, investors prefer bank CD portfolios and they have become credit conscious.

That also means that we don’t invest in such paper. My not buying them is not necessarily a view on credit quality. It is my view on liquidity of the paper and my investors wanting to invest in non-realty and non-construction papers.

If risk appetite has returned to the equity market, why are debt investors still risk averse?

The main issue is that you are not talking of the same investor. Investors in debt funds are institutional investors. They invest in liquid funds just to park money temporarily. Their boards are not going to allow any credit risk. Short-term bond funds invest 90 per cent in corporate bonds.

But these are of 1-3 year duration, with a focus mainly on triple-A rated bonds. Even in longer-term income funds, investors prefer triple-A rated papers. If you do want to go down to double-A paper, they still prefer frontline banks.

The mutual fund industry was a big source of funds for Indian companies last year. But with the greater ‘credit consciousness’, has this source of funds dried up?

I would say for the NBFCs. If you take the portfolios of most mutual funds in the debt segment, they have always been highly tilted towards banks, financial institutions and NBFCs.

I would say as a percentage of exposure, manufacturing would be 20-30 per cent of the corpus. This is because manufacturing companies don’t issue much paper. Realty companies and certain sectors like construction tap bond markets, but not sectors like media or technology.

Now realty and construction companies will not get much money because of the flight to safety. So what we are left with is banks and NBFCs. Banks and financial institutions are getting more money than they used to. But finance companies are surely getting less money compared to what they used to, especially for 1-3 years.

They are still getting the 3-6 month money from the liquid funds, but have shifted to bank funds for longer term funding. Mutual funds have also seen a 50-60 per cent fall in assets managed in the 1-3 year segment, with the FMPs drying up.

Is the recent rally in equity markets prompting investors to switch out of debt funds?

No. That’s a wrong impression that everyone has. In India, the investors in debt and equity funds are different. A small percentage of investors may switch between liquid funds and equities based on how they perceive market conditions.

But the corporate investors in debt funds will never invest in equity because their core mandate doesn’t allow that. We are seeing a significant shift from liquid funds to short term and income funds. These are not only institutional investors but retail, individual, HNIs, and so on.

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