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Increasing Portfolio Maturity Prudent?

There has been considerable talk on the change in interest rate cycle. As a well informedinvestor you may be tempted to invest in long term bond funds. But before taking such a call, we

have analyzed whether fund managers are moving in a similar direction and whether investing in

long term debt funds is a prudent move.

Usually in a rising interest rate scenario, investors park their money in short-term debt funds,

whereas when interest rates fall, investors choose to invest money in long-term debt funds as

there is an inverse relationship between bond prices and bond yields. When the interest rates arerising, bond prices fall and the fund manager can reduce the duration of the bond, as it will limit

the interest rate risk and also provide more flexibility to realign the portfolio. But when the

interest rates are falling, the fund manager is likely to increase the duration of the portfolio.

However, at present, even though interest rates have softened, not all fund managers haveincreased the duration of their portfolios. We looked at data on an aggregate level to understand

the overall direction of the debt fund industry. We found that the maturity trend of gilt and long

term debt funds suggests that since March 2012 fund managers have been steadily increasing the

maturity profile of their portfolios. This should ideally be a sign to enter into long term debt andgilt funds, however, investors will need to check their return expectations. Those who recall the

heady returns of 2009, when gilt funds returned 20%-30% may be in for a surprise, as theeconomic environment today is starkly different from 3 years back.

Tread with Caution

Most fund managers are treading with caution. This is because tight liquidity has forced shortterm rates on an upward trajectory, which in turn means that the shorter end of the curve offers a

better risk-return trade-off. Another reason has been that the government borrowing is large, and

an increase in crude oil prices could further pressurize the government to increase its borrowing.An increase in the fiscal deficit would play spoil sport with any recovery in the bond market, as

was evident in April 2012. On 17th April 2012, the RBI reduced the repo rate by 50 basis points,

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which was higher that expectations. While the bond markets did respond positively to this, the

rally was short-lived as pressure on the fiscal deficit seemed eminent. Following the rate cut, the10-year benchmark bond fell 11 basis points, only to rise by 33 basis points by 30th April 2012.

The clear slowdown in growth to 5.3% in Q4FY12, was much lower than last years figure of

9.2% and previous quarters reported figure of 6.1%. This may prompt a decrease in interestrates; however, as one fund manager pointed out, the investment cycle revival would require a

much higher reduction in rates.

In a nutshell, data points to increasing portfolio maturity, however, the investment environment

is fraught with many uncertainties, which could undermine the current strategy of going longer

on the yield curve.