Time to invest in short-term income funds

The new Government’s annual Budget (fiscal deficit roadmap) and steps to bring down inflation will shape market sentiment in the near future. The RBI’s view that the extent and direction of further policy steps will depend on unfolding data reinforces this view. But if inflation moderates in line with the baseline projection, further policy tightening is not anticipated in the near term.

The consumer price inflation (CPI) as well as future expectations of inflationary pressures will play a key role in determining the RBI’s future action.

But high supply of G-secs in the months of May and June 2014 may keep yields under check. Also, a weak monsoon due to El Nino conditions, if it happens, may impact food price inflation and pose a challenge for the RBI. This will have a direct impact on the market sentiment and the RBI’s future policy action.

However, the shorter to medium end of the yield curve looks attractive as the cost at the shorter end will continue to remain high. This should benefit short-term income funds and ultra short-term funds.

Headline CPI rose 8.59 per cent in April 2014 on expected lines, as against 8.31 per cent in March 2014. Food inflation rose to 9.79 per cent from 9.08 per cent previously. On the other hand, core CPI remained largely sticky, moderating marginally to 7.80 per cent in April from 7.82 per cent in March. Also, the spread between the repo rate and nine-month to one-year money market instruments is on the higher side and can contract over a period of time as money flows into the banking system.

The 10-year benchmark government security traded in the 8.7-9.1 per cent range during the last two months. Bond yields rallied in May on expectations of a stable election outcome and moderate inflation trend.

India’s economic landscape has improved in the last three months. The monthly trade deficit has narrowed on account of various steps taken by the earlier Government. Foreign exchange reserves have increased since September 2013 due to better-than-expected inflow on account of the FCNR-B deposit scheme and Tier-1 capital borrowing by banks. We also feel investor sentiment has improved lately as market participants believe that India is now in a better position to deal with external factors compared to last year. We also believe that the RBI may take a balanced approach between growth and inflation in its monetary policy, going forward.

On the other hand, government bond yields are closer to their peaks. In fact, FII inflows into fixed income securities resumed in December. Based on these factors, we believe that the risk-reward ratio could be in favour of investors. Investors can consider investing in funds with higher average maturity, as the worst may be behind us. However, stay with quality funds that can be redeemed easily.

While the known risks are inflation, emerging market currency weakness and debt outflows, there may be some unknown risks. During such times, it may be prudent to stay invested in liquid assets.