This period has encompassed the India Millennium Deposit inflows in Sept 2000 at one end and this years busy season credit policy at the other extreme. The effort to induce economic growth has seen the bank rate fall from eight per cent in July 2000 to 6.25 per cent this October.
This is the lowest level that interest rates have dropped to since 1973. The cash reserve ratio (CRR) has also inched towards the Reserve Bank of Indias (RBI) target level of three per cent. It is currently stationed at 4.75 per cent.
In this period, the 10-year government paper has moved from a yield of 11.71 per cent in November 2000 to touch a historic low of 6.31 per cent recently. The seven per cent yield level was thus relegated to history. The five-year AAA rated paper also created history by falling under the seven per cent mark. Along this journey the government has amply supported the RBI. Thus interest rates on administered savings have also been brought down significantly. In each of the past three years, the run up to the Budget has witnessed the government slashing small savings rates ruthlessly. If it was a 0.5 per cent cut in February 2002, the previous years have also had their share of cuts in administered rates.
This has created a great deal of unhappiness amongst fixed interest investors. And the reason is obvious a one-year fixed deposit in 1998-99 returned nine per cent and today the return is six per cent. Similarly, public provident fund returns have fallen from 12 per cent a few years back to nine per cent.
The confluence of these factors has seen debt funds deliver an average of 15.73 per cent in 2001. As compared to this, debt fund returns were 10.94 per cent in 2000.
As interest rates fall, older papers offering higher coupons become more attractive. Greater demand for these papers results in their price increasing.
Funds capitalise on this opportunity by holding on to longer dated papers when they feel that interest rates are going to come down.
Trading profits increase the funds yield over what would have been generated from just coupon payments. Thus in 2001, the CRR was cut by an incredible three per cent.
The bank rate was lowered by 1.5 per cent. Deposits continued to grow at a scorching pace and credit offtake was quite low. This excess liquidity created higher demand for debt papers. As their prices soared, yields fell. Banks played the gilt market, as this was the best avenue for them to generate returns.
Debt funds have also topped in their gilt exposure. These securities are the most heavily traded debt instruments. Their liquidity also makes them volatile. And so fund returns have tended to be more volatile this year, especially as funds have targeted the longer end of the gilt curve. The other parts of the investment universe of debt funds corporate bonds have also seen their share of action. When yields from gilts shrunk, funds have moved towards picking up lower rated papers. Specifically AA rated corporate bonds have been much sought after. The high coupon has been used to offset lower returns from other instruments. Funds have also placed bets on an upgrade of these instruments. The most highly rated corporate paper-AAA bonds-have also moved southward in line with other instruments.
The spread of a 5-year AAA instrument over gilts of the same maturity is down to 0.55 per cent. At the start of the year, the difference was 2.05 per cent.
As returns have started to contract, funds have started to take a closer look at expenses. Lower expenses translate into better return for investors.
Mutual funds, conscious of corporate clients concerns, have launched new schemes exclusively for these investors. There have been explicit statements that expenses will be kept low. There is another trend of launching new and innovative products.
Aggressive debt funds which will target particular segments of the bond market are a new attraction. Exposure to international debt securities is also being looked at seriously. There is now a fund that invests exclusively in AA papers.
The returns generated from debt funds in 2001 and this year too are exceptional. So is it that investing in debt is the way out I do not think so for no one can predict the markets.
Rather those who have had an asset allocation plan would have benefited the most, as no asset allocation is complete without a significant debt portfolio.
And debt mutual funds are the instruments that allow investors to benefit from the price changes in bond markets. Going forward these will now move more in line with other fixed income instruments.
My picks among debt funds are JM Income Fund, Birla Income Fund and Templeton India Income fund.
JM Income Fund-Growth: One of the oldest income funds in India this scheme has always found a place among the category toppers. In the year to date as on December 19, 2002 the fund has generated 15.67 per cent.
Birla Income Plus: This is one of the largest bond funds around. A one-year performance of 15.83 per cent along with a three and five year annualised return of 14.53 and 13.69 per cent make this a solid core holding.
Templeton India Income Fund: This fund is an attractive pick for the stability with which it has generated. Year to date returns of 14.5 per cent as on December 19, 2002 and a five year annualised return of 13.72 make this a good long term pick.