Why Short Term Debt Funds Now?

Posted by: Uma Shashikant on Wed, Jan 5th, 2011

The heightened levels of short term interest rates, leading to an inverted corporate bond yield curve has made decisions tough for investors in short term debt funds. It was expected that the liquidity crunch in June, triggered primarily by the 3G auctions, would ease soon.  The persistent shortage of liquidity extending into the last quarter of the financial year has been a surprise to many. Borrowings from the LAF window of the RBI persist, though the volume has reduced from Rs.1 lakh crore plus seen last month. The key factors contributing to the liquidity crunch are:

  1. Lack of government spending
  2. Persistently high levels of currency at hand with public
  3. Low rate of growth in bank deposits

It can be argued that liquidity pressures tend to ease over time as rates are hiked to attract demand.  The 3-month CD rates are over 9% and the 1-year CD rate is at 9.5% representing a steep hike of over 200bps from the levels seen only six months ago. But the last quarter of a financial year suffers a cyclical increase in supply from both corporate and banks, which should result in heightened rates and tight liquidity.  Given the typically low level of government borrowing in the last quarter, corporate issuances are higher, and deposits are also priced aggressively.  Liquidity pressures may only ease in the next fiscal, as deposit growth and government spending pick up.

 

The high rate of interest offers the opportunity for accrual products in the short term funds space.  A slew of 370-day FMPs are being launched to lure the investor who likes to cash in on the high rates in the short term markets.  If we assume that the liquidity crunch may ease in the first two quarters of the next fiscal, this product may capture only the accrual leg of return, missing out any mark-to-market gains. Also, FMPs only fit strategic asset allocation choices that do not envisage any mid-course correction in allocation during their tenure. 

 

Short term debt funds may offer a higher flexibility in riding the changes in liquidity and the reversal to a normally sloping yield curve.  They would benefit from the high accrual until the liquidity crunch lasts, and benefit from gains when rates eventually drop. If one worried about the policy rate hikes, the accrual gains in the market are currently far higher than losses from rate hikes.  However, investors who bought into the short term debt story last year are in losses now.  They have made mark to market (MTM) losses due to the sharp increase in short term rates and are wary about the product.  Short term funds had then invested the high inflows into 1-year tenures, and now have limited ability to make up for the MTM losses of that portfolio, from interest income in the newer CDs and CPs. Short term funds that see inflows now, hold the ability to reinvest into higher accrual products during a crunch, and possibility of making gains when yields stabilize. This flexibility is not present in the FMP that only locks accrual incomes at a given point in time. 

 

A fund manager recently told me that investors like to time their investments, but they almost always get it wrong, because they do not buy into an opportunity but only after it has manifested. May be that story is waiting to play out in the short term debt fund market.

 Posted by Uma Shashikant on Tue, Jan 11th, 2011 7:17:21 am

FMPs also are subject to valuation norms, but there will be no MTM impact to the inevstor who holds the FMP until maturity. CPs and CDs are also now subject to valuation.
 Posted by Srini on Sat, Jan 8th, 2011 10:16:10 pm

1. Do FMP's too get the effect of MTM reflected in their NAV's? As their portfolio normally contain CP's, CD's
 Posted by Uma Shashikant on Sat, Jan 8th, 2011 8:30:54 pm

The long end of the curve is likely to continue to remain under pressure, for all the reasons listed by Sumit. My sense is that heightened government borrowing may become the norm, keeping long term yields higher. My focus is on the opportunity provided by the inverted curve at the short end. Deposit and CP pricing now hold a liquidity premium, which is larger than normally seen. With government spending coming in, this situation could ease, perhaps in the first two quarters of the next fiscal. An FMP would have locked the current rates, and remain untouched. A smart short term fund, which hopefully does not get bulk flows as the rates ease, can make a smart gain if the liquidity premium wears off, and the curve normalises at the short end. The problem as pointed out by Suresh and Rupesh, is that investors may come in after the gains are visible, forcing the fund manager's hand to invest in lower accrual products after the curve has normalised. The call to take now is whether a mark to market gain will add to higher accruals, and whether the inverted short end of the curve will normalise. A smart short term fund will capitalise on this possibility.
 Posted by Sumit on Sat, Jan 8th, 2011 10:36:11 am

I, to a certain extent, agree with the fact that the sustainability of persistently high short term rates is unlikely, and hence short term debt funds may be more beneficial as compared to the FMPs from an investor's perspective. However, my concerns are as under: 1) Next year's borrowing calendar, which may be front-ended in the first half of the FY is expected to suck out liquidity and may result in the rates continue to be at elevated levels. 2) With the credit growth likely to pick up as against sluggish deposit growth, it may put upside pressure on the yields. 3) With the govt spending on Infrastructure projects to increase and the sources to raise funds are limited, it may likely put burden on govt to borrow more and hence may prevent the yields from softening. Your comments pls..
 Posted by Rupesh on Thu, Jan 6th, 2011 12:23:28 pm

I am little new on this. Would like to know , just to confirm what i understood is Short term debt fund will be better than FMp's in this market ?
 Posted by K R Suresh on Thu, Jan 6th, 2011 9:32:13 am

Investors many time judge the situation and consequences wrongly. After many years of study and experiencing many situation why the investor get it wrong?

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