Yields to fall – Focus on Income Funds

Inflation has started coming down. WPI, the official figure for measure of Inflation came down to 9.97 per cent, 0.03 per cent shy of two digits. The RBI concern on ballooned inflation, a shift of focus from growth to inflation led to a series of monetary policy measures this year, already four times witnessed. More worrisome is the fact that the inflation is no longer food prices driven; in fact it has become more generalized. Non-food inflation has risen from almost zero level in Nov 2009 to 10.9 per cent in June 2010, contribution 70 per cent to inflation.
The bond yields rose abruptly in India, however, the bond yields came down globally. For the first time in its history, the 10-year Indian and US bond yields are facing a divergent state.

The G-Sec markets witnessed hardening of yields in July and Aug 2010. The 10-year G-Sec Bond and Short Term Bonds’ yields have spiked in the recent past; which we believe that they may go up further projected the advance tax outflows in Mid September. The short term yields (1-year CD and CP) have already spiked by 200 bps in the last 3 months. The benchmark bond 7.80 per cent 2020 has already touched 8.08 per cent, currently hovering at 8.03%. It touched its four months high since May 2010. The RBI is still not comfortable with the inflation figures and the market opines that it may go with further rate hikes in the upcoming Monetary Policy meet due in mid-Sept.
We believe that the G-Sec yields in long term will follow its logical course of softening. The reasons are:
• Softening of inflation in coming months
• Improvement in Government revenues in the form of improved tax inflows, 3G and WIMAX auctions
• Reduction in fiscal deficit, if the excess revenue is used efficiently
• Spread in the Repo rate and 10-year G-Sec rate (already at multiple year high) should reduce
• Liquidity is bound to improve; temporarily we might witness liquidity deficiency in the system
• For the first time since 2002, interest rates in India are divergent to US yields (Check the above table)

Since US government continues to follow an expansionary monetary policy to revive growth, the Fed has kept its interest rates abysmal low for another extended period. However, in India, RBI has shifted its focus from good GDP/IIP growth to inflation management; therefore, we witnessed tightening of monetary policy. When inflation comes under control over next few months, bond yields (long dated bonds) will follow its logical course of softening. For those seeking to ride the yield curve at the longer end which could potentially ease in the 2nd half, we would recommend allocations to Income Fund having high average maturity. In the above stated scenario, the income funds stand to benefit with a time horizon of 12 to 18 months.