A very interesting story is likely to unfold in 1-3 year segment on the yield curve. Most of the market participants are in consensus about a downward bias on the yields of various maturities based on various factors which I have enumerated in my last note on AXIS Constant Maturity Scheme. I have given reasons as to why going forward based on both fundamental factors & RBI intervention, yields will take a southward journey.

Consider the following figures to understand the full impact of what I am about to enumerate:

(SOURCE: RELIANCE MUTUAL FUND)

Hence, as can be observed from above, there has been a major impact on the short end of the yield curve (almost 373 bps) v/s long end of the yield curve (only 48 bps) inspite of the fact that RBI raised rates by almost 375 bps during that period. This can be partly attributed to liquidity tightness which is being witnessed over the past year or so due to various RBI actions & initiatives including CRR hike by 100 bps & partly due to FIIs pulling out of emerging markets.

All this was done to contain inflation which continued to hover above 9% levels over this period. All the efforts of RBI along with impact of base effect has brought inflation (food inflation in fact has gone negative) under 8% levels (currently 7.47%).

Hence, as mentioned above, now the general consensus is that RBI will focus on growth (which has come off significantly due to rising interest rates and other factors like global meltdown, etc) rather than inflation & announce measures which will help boosting growth once again. Some of the actions in their order of preference would be conducting OMOs to infuse liquidity (which RBI has already started doing), CRR cut & then interest rate cuts.

All the above will help in infusing liquidity & as is logical, this will impact positively the short end of the curve which was under pressure over last 2 years or so due to liquidity tightness. Also, the fact that 1 year segment had gone up by almost 300-400 bps (v/s only 50 bps on long end); this segment is very nicely poised to compress at a faster pace with RBI’s expected intervention going forward & make the yield curve steeper once again. Though, this will help compression at long end as well, the same might not be as much in terms of it’s impact as it should impact the short to medium term securities.

Hence, I would strongly recommend to invest in those short term plans which have an average maturity ranging from 1 to 3 years & which can capture the above story well. Some of these schemes which have already captured this story or are likely to capture the same  are as follows:

Update: “Pramerica Dynamic Fund” details were inadvertently published instead of “Pramerica Dynamic Bond Fund”. The NFO closed on 11 January 2012.

DISCLAIMER

Initially the Fund Manager created a portfolio of 50:50 of 2-5 year corporate bonds v/s CD & CPs of less than one year maturity by creating an average maturity of 1.75 years & capturing gross yield of 6.29%.

Thereafter, the Fund Manager took advantage of tightness of liquidity impacting short end of the curve by reducing exposure from 2-5 year corporate bonds from 50% to 30% & increasing exposure to 1 year CD to 70%. Yields in 1 year CDs had gone upto close to 7% levels. Said portfolio already had built in profits as one year CD rates post their investment had already started compressing to below 6.40% levels.

Since CDs valuation was done on accrual basis rather than MTM, NAV appreciation did not register this unrealized gain till recently. Currently the Fund Manager has booked profit on 50% of their 70% portfolio invested in CDs at levels between 6.15-6.30%. Hence, he is sitting on almost 35% of portfolio in cash & cash equivalents, 35% still in 1 year CDs, 30% in 2-5 year Corporate Bonds generating decent returns from various dates as shown below. From the time of his original investments on March 20’2010, 2-5 year corporate bonds have inched up by over 25 bps over last 3 months (which is getting reflected in slightly lower; though positive returns since inception).

The Fund Manager is now waiting for an opportunity to increase his portfolio in 2-3 year corporate bonds (which is still quoting between 7.20 to 7.55% & likely to inch up if there are rate hike announcements in April Credit Policy Review) & create higher average maturity & capture higher gross yield. The said portfolio should do well once, first half borrowing calendar gets completed & inflation trajectory starts coming down from August onwards due to base effect kicking in.

Kindly wait for the latest update on the said scheme post the Credit Policy Review to increase exposure to the said scheme with six month investment horizon.

Returns in the said scheme on various dates of our notes/recommendations till April 13’2010:

As per the offer document, of the above, upto 30% of the portfolio will stay invested in less than one year maturities. Also, the Fund Manager has taken a tactical call of investing another 20% (out of the allocation earmarked in CP/CD as the same was giving higher carry than parking under CBLO) of the portfolio in medium term debt of 2-5 year segment post the Credit Policy Review tomorrow. If the RBI hikes benchmark rates, he will be able to capture that higher carry.

Inspite of the fact that only 50% of the portfolio is invested in corporate NCDs of 2-5 years, the said portfolio has captured a very decent yield of 6.29% with average maturity of close to 1.75 years. Post the policy, the Fund Manager hopes to increase the Average Maturity to 2 years with gross yield between 6.50% to 6.75%.

Current attributes:

RETURNS SINCE INCEPTION I.E. FROM JAN 20 TO JAN 27: 6.73% p.a.

Markets have started discounting rate hikes coupled with CRR hike. However, most of the bankers & Mr. C. Rangarajan (Economic Advisor to PM) are of the view that to curtail inflation, RBI needs to suck out excess liquidity through CRR hike rather than tampering with benchmark rates in the near future. They also predict that even if there is monetary tightening in the near future, it might not result in rate hikes by the banks (due to excess liquidity & lower credit offtake).

Any effort by RBI to curtail liquidity in the system is constantly getting offset by huge FOREX flows on account FII inflows. Almost $17 bln had been pumped during 2009; causing the local currency to rise by almost 10% from its low it touched in March 2009 of Rs.52/$.

Also, Q2 growth of GDP numbers was mainly fuelled by the Fiscal Stimulus provided by the Government. If one removes the impact of this stimulus on GDP numbers, actual growth would come down by almost 150-200 bps on the lower side. This fact will also not be lost on RBI as & when they think of raising interest rates to curb inflationary pressures.

As the data shows, inflationary pressures are more to do with failed monsoon & its impact on agricultural produce rather than the manufacturing sector. Hence, since the inflation is more attributed to supply side issues; this once again gives credence to no rate hikes in the January policy.

AXIS SHORT TERM PLAN NFO LAUNCH- A RIGHT PRODUCT AT THE RIGHT TIME:

Keeping in mind the above background of current & future scenario of debt markets & various expectations by different market participants it is once again a good time to take some interest rate calls & duration calls in your portfolio; especially in the 3-5 year corporate bond segment.

AXIS Mutual Fund is likely to launch in the month of January 2010 NFO of AXIS Short Term Plan. With the current status of debt markets & high liquidity with low credit offtake, the said NFO can be compared (in terms of timing) to launching an equity Fund at a SENSEX of say 10000. As one can’t go wrong by investing in such an NFO, I would assume that one can’t go wrong by investing in an NFO of Short Term Plan of AXIS Mutual Fund (with at least 6 month investment horizon) as most of the negative factors are already priced in with additional following reasons adding credence to the investment story:

Spreads between 1 year & 5 year corporate bonds are at an all time high. Before the hiking cycle started post October 2004, market had already priced in these hikes (which RBI delivered over a period of time). The spreads actually came down.

1-5 year Corporate Bond segment also is very steep & is likely to benefit due to :

As can be seen from above, timing of the NFO of AXIS Short Term Plan could not have been better. Even if there are rate hikes in the Credit Policy Review slated on January 29’2010; the Fund Manager will be in a position to capture the same while building the portfolio. The said NFO is likely to collect funds before the Credit policy Review & hence will help him start on a clean slate without any baggage of the past.

As is likely, the said scheme is likely to have an average maturity of 2-2.5 years & is likely to capture high gross yields (based on current market rates) of more than 6.5%. This will help the investors capture both high accruals & capital gains with at least 6 month investment horizon.

Investors in the NFO of AXIS Short Term Plan will have the added advantage of no exit load (if invested during NFO period). This is not say that the investor should exit before March 2010. I would personally advise clients to invest with at least six month investment horizon; however, if one sees decent returns in their portfolio post March 2010, one will be free to exit before six month period (if investment done during NFO) .

I would strongly advise you to look to invest in the said NFO with a view to earn decent returns over six month investment horizon.