I have been recommending some of the debt schemes of Pramerica AMC since their inception. Fund Manager has performed very well even in the most trying periods of debt markets & rising interest rate scenarios. One of the schemes whose strategy is similar to that of Pramerica Treasury Advantage Fund (TAF) was launched in October 31’2011. The said scheme has a dual strategy of capturing high accrual 12 month papers & drawing down on their maturities & buying 15-18 month papers & capturing capital gains due to roll down effect. Besides that, as the name suggests viz. PRAMERICA CREDIT OPPORTUNITIES FUND, they would be having some play on some credit plays.

Most of the times credit opportunities denote that the Fund Manager would invest in lower quality papers and take some credit calls. However, it is not necessarily the case every time. In this case, the Fund Manager is likely to play on those credits which have upgrade possibilities (like one of their investments in Future Capital which was upgraded recently; giving rise to good capital gains) and such similar stories besides only taking credit calls. This helps the portfolio construct in two ways viz. 1) gives higher accrual at the time of investment & 2) gives rise to capital gains in case of upgrades & subsequent compression in yields of these papers.

I would strongly advise investment in the said scheme with such high YTM with one year investment horizon. I would also advise investment in all debt schemes of Pramerica AMC with following investment horizons:

Said schemes invest in high yielding corporate debt with very low average maturity. The strategy of the scheme is to invest in high accrual corporate debt with 1 to 1.5 years in residual maturity. Hence, with a holding period of one year (which is recommended to maximise your returns) an investor gets the following benefits:

1. Investor gets very high accrual of almost 9%
2. By holding it for one year; the investor draws down on the maturity & hence does not take Mark to Market (MTM) risk on those papers which are of 1 year or lower in their residual maturity
3. Even papers with 1.5 years in residual maturity now will have only 6 months of residual maturity left after one year. Hence, these papers will quote at a premium, giving rise to capital gains to the portfolio
4. Currently interest rates are at their peak. After a few months we expect the same interest rates to ease off giving rise to capital gains in the portfolio even before completion of one year. In such a scenario, the investor can take a call to exit after six months if they so desire; assuming they have achieved their returns targets

I would recommend 50% of your surplus cash to be invested in the said scheme & 50% in BNP Paribas Bond Fund. Past track record of Templeton Short Term Plan has shown that; if held for one year; the investor has earned the fully locked in YTM +/- 0.50% depending on whether the interest rates have gone up or down during that period.

Hence, assuming that interest rates are on the decline, with current YTM of almost 9%; the investor after one year of investment in the said schemes should expect to earn 9% plus on their portfolio.

I would strongly recommend you to invest in the said scheme with one year investment horizon. If you are confident of holding the said investment for more than one year, I would recommend you to opt for growth option to take advantage of Long Term Capital Gains Tax which will be 10% without indexation or 20% with indexation; otherwise get into dividend reinvest option which will attract 22% plus surcharge as Dividend Distribution Tax (DDT) on dividends declared & balance comes as tax free income in the hands of the investor.

For the following reasons & for the fact that today’s IIP numbers of 5.60% were grossly below market expectations of 9% ; factors which will be favourable for taking some interest rate and duration calls are as follows:

1. We believe G Sec yields have peaked out. Though currently breached 8% & is hovering at 8.03% levels, one will not be able to predict whether this is the high or will it touch 8.25% before cooling off
2. Historically, benchmark yields higher than 8% mark have not sustained for a long period. Last time when we saw this crossing 8%, RBI had devolved its auction bringing the yields lower in the end August
3. Inflation is likely to come down to 7% by December and to 6% by March 2011
4. RBI is nearly done with neutralization of rates. One can expect one more rate hike of 25 bps
5. Positive news on fiscal as disinvestment goes through aggressively
6. Lower bond supply from November, 2010 with Government borrowing less to the tune of Rs.10,000 Crs
7. Strong demand from Banks for SLR as they look to build their deposit base
8. The FII limit for Government Bonds has been increased by US$5 billion with residual maturity of over 5 Years. It has also further increased the corporate limit for infrastructure bonds with residual maturity of over 5 Years

At the shorter end of the curve:

After steep rises of 250 bps, markets appear to have stabilized and forwards are discounting more tightening from the RBI than what is likely to be delivered, there has been no difference between pre and post policy levels. On the contrary, because of quarter end factor, December papers which are now technically below 3 months have rallied 10-15 bps.

We also think money markets rates could continue to face pressure for next 2-3 months on account of liquidity conditions (which will start improving over the next couple of months).

Hence in the current market scenario what are the asset classes that are likely to do well which are the specific schemes that one can look at for various time buckets:

0-30 Days: Pramerica Ultra Short Term Bond Fund: Returns Expectation: 6.80-7.00% p.a.

Their NFO closed on September 23’2010 & has reopened for subscription on September 27’2010. One week returns as on October 06 ‘2010 was 7.29% p.a. as against the industry average varying between 6.25% to 6.75% p.a.

The scheme managed to capture the following:

As can be seen from above, without taking any MTM calls and with an average maturity of 65 days (much less than the general industry average maturity in the ultra short term bond category of 95-100 days); the scheme has been able to capture very high gross yield of 7%. These high rates at the shorter end are likely to continue with negative systemic liquidity. This will give ample opportunity to the Fund Manager to further enhance their gross yield by investing any incremental cash inflows into the scheme as well as by deploying cash component post the NFO.

This scheme can continue to outperform other Ultra Short Term Bond schemes till such time the interest rates remain on the higher side at the shorter end. They continue to delver daily annualised returns between 6.95 to 7.00% p.a.

For 90-180 days: J  P Morgan Short Term Plan:Returns Expectations: 7.00-7.25% p.a.

They have locked into high yields at the short end and now have nearly 80% of CD portfolio locked in 3-4 months CDs at yields of around 7.50%. The balance 20% essentially looks to invest in Gsec (15% – 5 year, 3-5%-10-12 year paper) at the current yields.

150-180 Days: Systematic Weekly Investment in ICICI Prudential GILT Scheme & Birla Sunlife GILT Schemes: Returns Expectation: Double Digit:

For various reasons mentioned in the first para & for the following more reasons I believe there is a short term trading opportunity in GILT Schemes. GILT/Income Schemes have not yielded good results over longer periods of holding. However, there have been times like now and like November 2008 to January 2009 wherein GILT schemes in spurts have outperformed any other asset class. I have been recommending weekly investment in GILT schemes on every Friday since July end Policy Review. The said strategy has paid off very well as can be seen from following table. Since we still expect some more action from RBI, the said strategy should be continued for a couple of more months, create an average of 8% or above & wait for one technical correction in benchmark which can drag the yields between 7.50-7.75% levels. One should then exit from this asset class altogether as new borrowing calendar in February will determine the course of the interest scenario for next Financial Year.

• The difference between the Repo and 10 Year is quite high and my view is that the next 50 bps of rate hike has already been factored in the 10 year yield
• The increasing yields on the govt. bonds and lower supply of long term corporate bonds has resulted in narrowing the corporate bond spreads. The current spread of 10 Year AAA Corporate bond over 10 Year Govt. bond is lower at 75 bps against the average of 106. I believe that the spreads will widen gradually resulting in outperformance of G Secs over corporate bonds of similar maturities
• The spread between the Indian treasury yield and the US treasury yield is at multi-year high even surpassing the highs seen in October 2008. The yield differential between US and India is at historic high, should decline
• Inflation has remained high. Food inflation has been growing in double digits for past many months. A good monsoon will likely result in record food grain production and partly because of base effect, I expect the inflation to coming down

Following chart shows how SIP of Rs.1 cr over past 12 weeks since July 27’2010 till October 12’2010 (an average holding period of 42 days) has done as on October 12’2010:

180-365 Days: Kotak Bond Short Term: Returns Expectations: 7.00-8.00% p.a.

The Yield on the portfolio has touched 8% with an avg. mat of 1.40 yrs though the average maturity appears bit higher the fund manager is working to reduce the same.

The short end of the yield curve was the worst impacted and the long end broadly remained flat and the liquid to illiquid spread also got compressed therefore funds with higher average maturity and relatively illiquid portfolio have out performed in the short run but going forward the short end is expected to do well from a risk reward basis.

Therefore investors who would hold on to their positions for next 3 months are likely to get similar spread over liquid plus going forward and the spreads likely to increase provided the rates do not move up.

365 days plus : Templeton India Short Term Income Plan: Returns Expectation 0.25 +/- the Captured YTM of the fully invested Scheme(Current Portfolio YTM 8.40%) :

I have been recommending investment in Templeton India Short Term Income Scheme from time to time. I have always believed and mentioned in these notes that this scheme is a PRODUCT FOR ALL SEASONS  where the investor does not have to either time the entry or exit or take any interest rate or duration calls on their own.

The Fund Manager has been able to generate returns close to the captured YTM over one year horizon on a very consistent basis. This is being done by a very active management of the scheme, taking calls on corporate bonds keeping in mind :

a) Higher YTMs

b) Spread Compression Stories

c) Upgradation possibilities

d) Roll down effect

e) Capital Gains

365 days Plus: Fortis Bond Fund: Returns Expectations: 8-10% p.a.

Strategy of the scheme will make it an all seasons product. The fund Manager will take some high yielding credit calls, counter with some money market calls for liquidity with strict discipline of not creating an average maturity of more than 1- 1.50 years and no single paper to have residual maturity of more than 5 years. This will ensure lower volatility in the portfolio.

Current scheme attributes:

Ideal portfolio break up:

1/3^rd in Money Market instruments

1/3^rd in PTCs

1/3^rd in High yielding AA-/A+ or higher credit rated corporate papers

If one invests with one year view, one can expect returns between 7.50-9.00% p.a. Roll down effect & capital gains impact can improve returns further.  Since they have monthly/quarterly dividend pay outs; it can be an ideal investment for those looking to have regular cash flows from their investments. Another important strategy of the Fund manager to protect the interests of the investor is to restrict further flows into the scheme once the scheme reaches a critical mass & once when interest rates start sliding down.

This call panned out well & benchmark 10 year corrected from a high of 7.45% to a low of 7.15% a couple of weeks back. This was the trading zone I had mentioned in that note.

However, very high food inflation number of 17.50% announced last week & higher than expected IIP/GDP numbers created some flutter in the debt markets. Also, statements by Dy RBI Governor Ms. Usha Thorat & by Mr.Rangarajan of having a relook at the easy monetary policy in light of the rising food inflation & that this inflation is not only supply side issue but also speculative in nature due to ample liquidity in the system has caused some rethink in the minds of the traders. Also, the same is getting reflected in firming up of prices in manufacturing sectors like automobiles, steel, cement,etc which can give rise to higher than expected inflation numbers in the next couple of quarters. Due to all these events of the past few days & statements by RBI & MoF 10 year benchmark has already crossed the psychological barrier of 7.50% & is currently quoting at 7.52%. Also new benchmark of 6.35% 2020 is also quoting above 7.60% levels & rising.

All these is a prelude to the imminent rate hikes & CRR in the forthcoming Credit Policy Review in January 2010. Market has already started discounting these news.

What will be the impact on Short & Long End of the Curve in case of Reverse REPO &/or CRR Hikes?

• Short end of the curve will start inching up. The same has already started happening in as much as 1 year/ 3 yrs CD/Corporate Bond rates have gone up by 40-50 bps over the past few weeks. 1 year CD has gone up from 5.05% to 5.50% & 3 year Corporate Bond has already gone up from 7.25% to 7.65-70%
• Though CRR hike will suck out liquidity; due to large systemic liquidity the same will not vanish in a hurry • On the day of the announcement there might be a sudden spurt at the short end; which can settle down post that to reasonable levels
• Long end of the curve need not be impacted; if at all, it should have positive impact at that end of the curve
• Short term plans will get impacted for a short span. Those schemes which have longer duration will be impacted more than the ones which has high accrual & lower duration ( like Templeton India Short Term Plan. Average maturity of this scheme is less than one year & gross yield is 6.76% inspite of 25% exposure to CD/Cash.This scheme with 25% in Cash/CDs should have great opportunity of investing this portion at higher levels when rate hikes come into effect & short end spikes up )

Once Again an Investment Opportunity at the Long End & Why:

• It is that band of the trading zone ( mentioned in my November 03’2009 note) when one can look to invest at the long end for following additional reasons
• As mentioned above, any rate hikes or CRR hike will have an immediate impact at the short end rather than the long end
• Year end buying by Insurance companies will boost long end rates
• Credit offtake still dismal which was evident when SBI cut their lending & deposit rates & the same was followed by other banks as well a few months back
• Next year Fertiliser & Oil subsidy should be on the lower side
• Hopefully no more fiscal stimulus packages need be announced in the next year which can increase the borrowing programme like in the current year
• If at all, fiscal & monetary stimulus packages might be rolled back gradually, giving rise to higher revenue collections & hence lower borrowing
• State Governments have collected a huge amount of approx.Rs.1 lac crores @8.50% in their small savings schemes; hence they also might have lower borrowing requirements next year
• With rise in GDP, revenue collections for the forthcoming years should improve dramatically
• Also, healthy disinvestment of PSU Equity figures which have been planned going forward alongwith collections from 3G Auction should also help in reducing Fiscal Deficit numbers

• With interest rates at the long end also inching up in anticipation of rate hikes; this can give good opportunities to Fund Managers managing G Sec & Income schemes to lock in higher gross yields in their portfolios. Also, by taking some exposure to good State loans ( quoting 100 bps higher than Central Loans) can also boost overall YTMs of these schemes

• All the above should augur well for Long Term Income/G Sec Schemes with one year investment horizon. Ideal time to invest will be when rate hikes happen & the rates inch up further to 7.75% plus. However, one can stagger their investments even at the current levels & increase their exposure post credit Policy review in January 2010

To figure out whether the same holds true for other schemes as well & that also till date, I have done one year rolling return analysis of some more Income schemes of different AMCs & come to the same conclusion. What this analysis shows is that if one invests in Income Schemes with minimum one year investment horizon, they have not gone negative (except for investments made between October’2003 to April’2004 & held for one year thereafter. Only these observations had gone negative marginally as interest rates had jumped from a low of 5% to 7% over one year with accruals also on the lower side at around 5-6% p.a.)

As can be seen from above, the number of observations range from 1400 to 3400 based on which scheme was launched when. Some of the schemes’ observations have started from as early as January 1996. Hence, a) number of schemes & b) number of observations justify assuming that Income schemes if held for more than a year should generally not generate negative returns in your portfolios.

Rolling Returns - Income Funds Jan 97 - Sep 09

Rolling Returns - Income Funds Jun 04-Dec 05

This analysis is done just to make the investors understand the importance of matching their investment horizon with the time required to hold the scheme under that asset class & not mismatch the two. If one invests in say Income schemes with less than one year investment horizon, it is possible that the said asset class may generate negative returns. However, based on historical data one can safely assume that if held for more than a year, one may not see negative returns under this asset class.

I am personally of the view that if one gets an opportunity of investing Income/GILT schemes on 10 year breaching 7.50% between now & March 2010 with fears of RBI tinkering either CRR or Policy rates or both by March’2010, one should grab that opportunity with one year investment horizon.

Next year’s Fiscal numbers should be better for following reasons: a) lower subsidy numbers, b) hopefully no more fiscal stimulus packages ( on the contrary some of the Fiscal Stimulus like reduction in service tax & other excise duties might be reversed thereby enhancing revenue collection) & c) with GDP growth rate between 6 & 7%, revenue collections should improve. Also going into next Financial Year, lean credit season will set in post April’2010 which should further aid the debt market story. Hence, if one invests at the longer end at an appropriate time as mentioned above & holds it for one year thereafter, one should be able to generate decent returns in the said asset class.