Fixed income investors will gain more by investing in mark to market fixed income mutual fund schemes rather than by investing in fixed return products such as FMP’s (Fixed Maturity Plans), fixed deposits or government run savings schemes. Mark to market mutual fund schemes are schemes that invest in government and corporate bonds of varying maturities, and the prices of these fixed income securities will move up or down depending on movements in interest rates.
Mark to market fixed income schemes include short and long term funds. There is a category of medium term funds but these funds are neither here nor there and can be avoided.
Short term funds invest in securities with maturities of one year to five years. Long term funds invest in securities that have maturities of five years and above. The yields on fixed income securities across maturities are attractive given the reasonably positive outlook for interest rates in fiscal 2012-13. One year money market security, which includes CDs (Certificate of Deposits) and CPs (Commercial Papers), yields are trading at close to 11% and higher while three and five year corporate bond yields are trading at 9.5% levels. Government security yields are lower than corporate bond yields, but are trading at levels where there is good scope for yields to come off. One year treasury bill yields are trading at 8.5% levels while five year government bond yields are trading at over 8.4% levels.
Short term schemes investing in a mix of government and corporate bonds and running an average maturity of three years, can deliver returns of 8% and above over a one year period even if yields do not change while if yields do come off by 100bps, returns can go higher than 10%. The chances of yields on fixed income securities with maturities of one to five years coming off are high given that liquidity, which is extremely tight in March due to advance tax outflows and fiscal year end demand for money, will ease going into April. RBI has cut CRR (Cash Reserve Ratio) by 125bps to release Rs 80,000 crores into the system and this liquidity will be felt in April. Easing liquidity increases demand for bonds with shorter maturities as investors arbitrage on the difference between funding costs and bond yields.
RBI is likely to cut repo rates, which are at 8.5%, in the coming months. The government has forecast a GDP growth of 7.6% for 2012-13 with inflation at around 6.5% and fiscal deficit at 5.1% of GDP. RBI’s estimates are unlikely to be much different from government’s estimates and as the economic growth has come off from 8.4% levels to 6.9% levels, RBI is likely to ease rates to give a spur to the economy. Lower repo rates reduce funding costs to the system leading to investors generating demand for government bonds and corporate bonds.
Long term funds investing in a mix of government bonds and corporate bonds can generate returns of over 12% if interest rates fall by 100bps. The interest rate sensitivity for long maturity bonds is higher than short maturity bonds and hence the higher return potential. Five and ten year corporate bond yields are trading at 9.4% levels while five and ten year government bond yields are trading at 8.4% levels. Long maturity fixed income securities have seen yields go up by 20bps on the back of the higher than expected borrowing announced by the government in its 2012-13 budget. The government is expected to borrow Rs 569,000 crores in 2012-13 through issue of dated securities against market expectations of Rs 550,000 crores. The rise in yields will be capped on expectations of rate cuts by the RBI in fiscal 2012-13.
The risk of investing in mark to market funds is that interest rates move up and prices of fixed income securities fall. However given that yields on fixed income securities are not very far from three year highs and given that RBI is more likely to cut rates than raise them and given that liquidity will ease rather than tighten, the outlook for interest rates is positive. Investors do not carry much risk in investing in mark to market schemes.