The ten-year g-sec bond yields, now at 7.9% levels, are above the decade’s average of around 7.6%. In that sense, HDFC Mutual Fund?s Shobhit Mehrotra, senior fund manager and head credit and Anil Bamboli, senior fund manager, believe the debt market is in a safe zone. In an interview with Muthukumar K and Chirag Madia, they said interest rates would remain range-bound over the medium term unless there are slippages on fiscal deficit targets. They even expect a bond rally in the next two years, provided inflation falls and the fiscal deficit mark of 3.5% by 2013-14 is achieved. They warn, though, that large g-sec issuances could play the spoilsport.

Where are the interest rates headed? Do you think the rates have peaked out at current levels or might inch up in the coming days?

We think long-term bond yields are likely to remain range-bound, given that fiscal deficit for the coming year is budgeted at 4.6% of the GDP, which is far lower than most people had expected. While there are some concerns on expenditure targets being met, oil prices continue to remain higher, which could lead to slippages on account of subsidies exceeding the budgeted figure.

A clearer picture would emerge towards the second half of the year. Till then, the market would be concerned as to whether revenue and expenditure targets are on expected lines. If they remain so, then interest rates could remain firmly within a smaller range from current levels. In case revenues are lower than estimated or even expenditure is more, then perhaps there would be concerns and yields could move up. But that concerns would be known only when the year progresses and it depends on the extent of slippage.

In such a scenario, where do you look at the 10 year g-sec yields from hereon?

In case any overshooting of expenditure is met through saving made from other expenditure heads, no extra borrowings might be needed. This could mean yields not spiking up and remaining range-bound. Also we don’t expect it move as high as 8.5% over the next six months.

Could there be a bull run in the making for debt markets?

Bond markets have not done well ever since equity markets have rallied with the climbing bond yields. From as low as 5% two-to-three years back, 10-year g-sec yields are close to 8% levels now. Bond market yields have gone up; so they have not performed in that sense. Over the last ten years, when we saw two market cycles, the average yields have been around 7.6% and currently we are above that. So one is in the safety zone in that sense. But it looks difficult for bond yields to come off very sharply because of the amount of supply that is there now.

Today, we have a borrowing programme that has almost doubled. So, to that extent, the quantum of supply is far large and we can?t have sustained rally unless inflation falls or things change dramatically. Over the next two years, the target is to cut the fiscal deficit to 3.5% by 2013-14. If they achieve that and the market believes that one year down the line they are on track to achieve that number while also bringing down inflation, expect a bull rally in the bond market.

How would rising prices of oil and other commodities impact India Inc?

Oil is definitely a concern along with other commodities, which in turn could impact oil and fertiliser subsidy. There is a certain degree of concern that there could be some slippages, which means the actual fiscal deficit could be higher than 4.6%.

What’s your view on the 30% dividend distribution tax on all debt schemes for corporate investors, announced in the Union Budget?

Certainly its a negative for the mutual fund industry as arbitrage opportunities would be reduced. Yet, we have to look at each product according to its category and investment needs. If we look at a liquid fund product, it still remains a viable product as corporate investors would continue to earn returns every day, while ensuring liquidity at short notice. So this product has its own place, despite arbitrage going away. Then, for short-term bond funds, investors usually take a ‘duration call'(or take a view on interest rates) and they don’t look at the product just from a tax arbitrage perspective. When it comes to retail investors, they will continue to invest as long as they are getting better post-tax returns over bank fixed deposits.

In the current scenario, what portfolio strategy are you adopting for long- and short-term bond funds?

On our long-term debt funds, we have relatively reduced the duration, but not brought it down to lower levels. We have maintained a duration of 7-8 years with g-sec exposure of 35-55% of the total portfolio. This is based on our view that in duration products, investors have given us money to remain invested and therefore we don’t want to take active cash calls by timing the market.

On the short-term bond we have closer to 15-16 months’ maturity. We have two products; firstly, HDFC short-term bond fund, which has exposure predominately to strong AAA and PSU bonds. Another short-term bond fund, which is called HDFC high-interest fund short-term plan, takes relatively more credit risk by increasing the exposure to AA rated papers category, NBFCs and other high-yielding assets.

Do you see any trend of fund managers moving towards high-quality assets at this juncture?

Debt fund usually don’t take higher credit risk?especially after the experience of 2008. Today, almost the entire industry prefers investing only in high quality assets.

How much hike do you expect from the central bank in the coming policy meeting?

The Reserve Bank of India (RBI) will probably increase the rate by at least 25 basis points in March and another 50 basis points next fiscal. However, we cant predict beyond three-six months as globally things are not stable and to some extent it depends on what will happen to inflation and how will commodity prices pan out. But in next three-six months, we might definitely look at a hike of at least 50 basis points as the central bank is still behind the curve.

What are the debt products investors have to look at this point of time for better returns?

Monthly income plans (MIP), though not purely a debt product, look very interesting at this point of time as they give a good amount of debt exposure along with marginal equity exposure. Over a three-year period, MIP returns have outperformed the returns of bank FD. Apart from that, fixed maturity plans (FMP) is a seasonal product to consider given the higher bond yields at this juncture.

Have the credit spreads of g-sec over AAA corporate papers narrowed?

Corporate bond spreads have narrowed, but a lot of it is because the supply of corporate paper has not grown as much as that of government securities. Government yields have been high because we have seen a quantum jump in supply. In the last three years we have seen two-three times jump in issuance of government papers while on the corporate bond side the supply is still limited because the investment cycle has not taken off in a big way.