An investor needs to segregate themes which are temporary & those which can be sustained over longer periods of time & themes which lie in between. This is important because after investing in themes which are temporary (like Religare Active Income Scheme-which can work only when the yield curve is steep & not flattish); one needs to take a disinvestment call also at the right time (disinvest when the yield curve starts become flatter again). Here there is no interest rate call or duration call.

Whereas schemes like Templeton Short Term Plan, BNP Paribas Bond Fund & Pramerica Treasury Advantage Scheme are sustainable strategies on an ongoing basis with one year investment horizon. This theme plays on draw down and roll down effects; hence taking no interest rate or duration calls.

In between these two lie themes which work due to changing fundamentals of the debt market like traditional Short Term Plans with 1.5 to 2 years in average maturities. These schemes are currently trying to capture high accruals without taking any credit calls by buying say March 2012 CDs and adding on 2-3 year NCDs of high credit ratings which again give higher accruals. This theme relies on fundamentals in the market & takes both duration & interest rate calls. Based on the market fundamentals, Fund Manager gets an opportunity of locking in higher returns & hopes for compression story in future.

This theme will work for slightly longer than the one mentioned above due to the fact that fundamentals of the debt markets do not change overnight. Generally, these fundamentals will carry you through for at least 6-12 month periods without changing the scheme attributes drastically.

What are the fundamentals which work in favour of these traditional short term plans? :

• Slowdown in domestic growth story; thereby slower credit offtake and lower demand for liquidity
• RBI’s clear focus on controlling inflation rather than growth at least for the next quarter or so
• Interest rates should peak off by September 2011 by which time RBI would have increased the benchmark rates on a couple of occasions by not more than 25 bps each time. News that is already discounted
• With mounting pressure from banking sector; RBI might pause rate hikes. This might give rise to a technical rally in the debt markets
• Inflation to remain in 9% plus zone till such time entire impact of fuel price hike reflects by September/October. Hence, inflation might start to slowdown with full impact of fuel hikes getting accounted and reduction in general demand & growth due to constant RBI interventions
• Systemic liquidity to be negative & range bound between Rs.30,000 Crs to Rs.60,000 Crs. A comfortable position due to the fact that credit offtake is slower and hence there is no liquidity premium as in the past
• Deposit growth outpacing credit growth pace; thereby reducing pressure on banking system to issue CDs. Expectation of weaker credit offtake in the coming months has also meant reduced rollovers of CDs in the market and hence a check on the rates from hardening significantly. 3m rates have come down by more than 75bps since March, and 1 year rates have dropped by about 50 bps during same period.
• Even the spreads between  G Secs & AAA rated bonds would peak in this cycle and then start compressing
• Overnight Swaps curve (proxy for funding costs on the market) has inverted since mid May 2011 till now. This effectively implies that the one year rate one year hence is expected by the market to soften on the back RBI either pausing hikes in the policy rate or cutting rates (dovish stance) to revive growth momentum in the economy
• At some time in the near future when inflation starts peaking off, RBI will have to revisit their monetary policy stance of concentrating only on inflation & not growth. They will have to take steps to revive consumption & growth & infuse liquidity back into the system

There are a number of short term plans in the MF space which are well positioned to give decent lower double digit returns over next 6-12 months:

I would recommend investing in these schemes with 6-12 month investment horizon.

As expected, 3G money outflow has resulted into a deficit in system liquidity (+42000cr surplus for week ended 21st May to -59990cr deficit for week ended 11th June). As a result, short term rates have reacted upwards – overnight MIBOR at 5.35% (3.80% in May), 3m CD at 6.15% and long rates as follows:

While advance tax outflows (approx 30-35k cr) seem to have been priced in current liquidity calculations, BWA auction outflow of approx 39k cr will happen by 21st June and is likely to put further pressure on liquidity. One more negative is just announced WPI inflation of 10.16% for May against expectations of 9.6% with extremely hawkish revisions (11%) for the previous month. Street is still divided over whether this will lead RBI to tighten in a more aggressive manner than spelt out earlier (“baby steps”) when global outlook is still uncertain and central banks there clearly in no hurry to withdraw accommodation.

Even after reacting upwards, current levels have maintained steepness. As RBI is prepared to provide system liquidity at 5.25 (by temporarily cutting SLR), 3m onwards curve starting from 6.25 provides enough cushion. And as system liquidity eases by government spending (approx 10k cr/week) and Gsec maturities (51k cr by 28 Jul), rates will slowly drift towards lower band of corridor – 3.75%. Even if we assume that RBI will hike by 50-100bps by December (50bps as per “baby steps” and 100 bps in aggressive stance), current levels provide good opportunities of roll down (6m-1y spread at 50bps) and capital gains. AXIS STP (ASTF) has maintained the duration of 1.15 years (range: 1-3Y) during the current liquidity tightness. They plan to increase it gradually in coming days to play out the steepness for a period of next 6-9 months.

As mentioned in my earlier notes, this is the right time to capture short term rates in your portfolio through aggressive allocations to schemes like ASTF with at least 6 month investment horizon from the point of view of roll down effect that it will have as well, higher accruals without undue increase in portfolio duration & compression effect & subsequent capital gains that it will bring in post July once Govt starts spending alongwith G Sec redemptions that will take place in July.

Short End & Long End of the curve are moving in opposite directions. Reasons are obvious and some of them can be traced to the same economic and commercial activities happening in the markets. Like better than expected ( almost double) collections in 3 G Auction of Rs.68000 crs is one of the reasons for positive movements in the long end of the curve; whereas short term borrowings by the Telecom Companies (Telcos) to bridge their financing requirements by May end are creating ripples in the short end of the curve.

When I last published my note on AXIS Short Term Plan on May 14’2010, rates at the short to medium term were as follows ( as on May 12’2010) :

As can be seen from above, short end rates between 3 months to 1 year have gone up between 70-75 bps to 20-25 bps already in a very short period of time. This sudden spurt in yields can be attributed to the temporary borrowing being undertaken by most of the Telcos who had successfully bid for 3 G auction & have to shell out funds before May 20’2010. They are allowed to raise cheaper funds through ECB route within 1 year from now. Hence, this temporary bridge financing has shot up the 3 mths CP to 1 year CP & CD rates. Tata Tele raised one year CP at 7.25% & AIRCEL has raised the same tenor CP at 9.75%.

Also, Rs.68000 crs raised under 3 G auction is likely to be going out of the system ( till Govt does not start spending ) & going into the Govt coffers. This is going to create a mismatch of cash flows in the system. This coupled with advance tax outflows might take systemic liquidity into negative. In such a scenario, the banking system also might redeem their MF investments of close to Rs.1 lac crs parked by them in liquid/liquid plus schemes. In such a scenario, we might see the banks accessing the REPO window at 5.25% levels for a short while.

All the above will give ample opportunities to the Fund Managers to invest in 1-3 year papers in much higher yields when short term rates peak off mid June’2010 & creating a slightly higher average maturity profiles of between 1.50 to 2 years. Most of the Fund Managers ( not necessarily all) would have booked their profits in their CP/CD & 2-3 year papers by now & should be sitting on cash to take advantage of these developing situations.

Another factor which will be determined by the demand/supply situation post July 01’2010 (post the new SEBI guidelines kicking in for valuing securities on MTM basis) is the valuation of papers between 91-365 days. If most of the liquid plus schemes shy away from taking slightly higher average maturity/MTM calls in their liquid plus schemes, these papers will have no takers for some time.

Hence, one needs to carefully study impact of all these factors on the shorter end of the curve before investing in short term plans going forward. If at all, one can take a call of exiting aggressive short term plans which have higher average maturities & higher component of MTM papers & stay invested in those schemes which were lower in duration/ invested more in CDs ( with in built profit like AXIS Short Term Plan & Kotak Bond STP, which can be sold at profit) & those schemes which have already booked profits & sitting on cash (like Canara Robeco Short Term Plan which has booked profits on their CP/CD & NCD portfolio & sitting on 50% of the portfolio in cash).

I would recommend investment in this asset class with at least 6 month view starting second week of June’2010.

As against the above, another interesting story is unfolding on the longer end of the curve. I had first given following reasons for looking at the longer end of the curve as early as December 07’2009. I had mentioned following reasons for looking at the longer end of the curve:

“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”

As can be seen from above points, most of the reasons why I had thought long end of the curve should do well are panning out quite well one by one. Besides almost double the collections of 3G auction collections & healthier tax collections, there is still untapped potential on the disinvestment side. Also, with European crisis pushing demand for safe heaven government debt like US treasuries as well Indian treasuries, oil at $70/bbl, Indian bond yields have fallen to their lowest levels in last 5 ½ months; currently 7.80% 2020 is quoting at 7.33% against 7.55% on May 12’2010 & 7.80% when it was first auctioned in April’2010.

With better than expected collections of 3 G auction, there are rumors of either a couple of auctions getting cancelled or Govt borrowing programme getting truncated. Since we are in a similar situation like mini 2008 global crisis, RBI might have a rethink on their medium to aggressive rate hike stance to a slower pace of rate hikes. Also, there is a possibility of further hikes in FII limits of buying GILTs. All this will augur well for the long end of the curve. There might be a slight blip in this story in the month of June for reasons mentioned above affecting the short end of the curve as long end also might move in conjunction with short end due to depressed sentiments.

In such a scenario, 10 year benchmark may retrace some of the recent gains & bounce back to say 7.50% levels in June’2010; thereafter it can settle sub 7.25% levels. One can look to invest in long term GILT/Income schemes in mid June’2010 or once it starts retracing some gains from current levels.

Current Parameters of AXIS Short Term Plan ( as on May 11’2010):

Portfolio Composition as on 20th April:

Post RBI Policy Review in April, with lower than expected rate hikes, debt markets rallied for some time as is evident from below yields. However, with Government spending more than their current borrowing ( thereby going negative with their account with RBI by almost Rs.30,000 crs) & hence the funds from 3 G Auction getting transferred to Govt coffers for some more time ( till it starts spending again); markets gave up some early gains & yields started inching up:

Yield Curve still remains very steep; giving ample opportunity for the Fund Manager to:

• Capture higher yields by increasing average maturities marginally
• Roll down effect will help the current portfolio of almost 74% in high yielding March CDs. New MTM guidelines will help boost NAVs of the scheme due to current in built profit in the scheme even if the Fund Manager does not book profits. Post July 01’2010 all the securities beyond 91 days in maturities will have to be marked to market; thereby boosting NAV of such schemes
• Ample cushion available in the current portfolio construction if there is a rate hike between now & July with 74% of the portfolio in high yielding CDs
• Higher yields in 1-3 year papers will help Fund Manger to capture higher yields for fresh inflows
• 3G money transfer effect on liquidity, even if it actually transpires, is likely to be a short-term phenomenon. RBI, in its annual policy, has acknowledged the need for “supportive” liquidity conditions so that Government’s borrowing program is not hampered. Also, credit-off take tends to be relatively lower in first half of financial year.

All the above points augur very well for both existing investors as well as new investors to invest in the said scheme.

Current Steepness in the market:

I would strongly advise investment in the said scheme with at least 6 month investment horizon.

Hence, as can be seen from above themes, most of these were high carry, compression stories, lower duration which have insulated investors from rate hike & CRR hike shocks at the same time generated much higher than liquid plus schemes on an ongoing basis.

RBI has hiked CRR from 5% to 6%,
Repo Rate from 4.75% to 5.25% and Reverse Repo Rate from 3.25% to 3.75% from July 2009 to April 2010.

Following sheet captures returns generated in some of these schemes I had recommended from time to time (they are all published on my blog: msjcapital.com on the dates mentioned) & how they have performed till date: