The spectacular run of debt mutual fund schemes is likely to fizzle out by the second half of the current calendar year. The industry itself expects to generate half the returns in the full year it had raked in last year.
The main reason cited for the limited expectation on returns, amounting to 8-9 per cent this year against last year's 20-25 per cent, is the widespread belief that interest rates cannot fall further. Even if they do, the correction will be nowhere close to the precipitous fall seen throughout last year. The other reasons include the low inflation rate that is resulting in stable real interest rates, and ample liquidity in the system. On the flip side, interest rates may even inch up in the course of the year, led by higher government borrowings.
Lower interest rates mean higher prices for gilts and bonds, which translates into bumper profits for funds. If, however, interest rates remain stable, funds can only generate profits by churning the portfolio. If interest rates rise, funds will have to book losses in the value of their holdings.
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"Last year interest rates declined as much as 2.5 to 3.0 percentage points, which is the highest ever in a single year. The rates have almost bottomed out and the likelihood of a further softening can be expected, but only by another 50 basis points at the most," Dhaval Dalal, head, fixed income, DSP ML Investment Management said.
The funds will be closely watching the interest rates paid by the government on the public provident fund and other savings schemes. "There is no doubt that interest rates on this instruments will be linked to the market, but it is a matter of time," Milind Nandurkar, head, fixed income, Sun F&C said.
Credit offtake is low and the liquidity in the system is brimming over. There is hardly more room for a further softening of interest rates either domestically or globally, especially in the US. There are signs of both the US and Indian economies picking up. Higher economic growth rarely calls for a further lowering of interest rates and thus there is scope of some hardening in the next few months, sources said.
"Markets generally display the fear or hopes of the near future in their behaviour and it seems US markets have already realised that the Fed may not slash rates any further," Dalal said. In all likelihood, the US Fed may tighten rates as early as in June or July and the markets will display the signs before hand. This will have a cascading impact globally.
Moreover there is a tendency of money moving from one sector to another in expectation of better performance, he added.
"And this has already been witnessed in the US with money moving from debt to equity in the past couple of months," Dalal added. This, in turn, can be construed as a hint that debt funds will not match the astounding returns they gave last year, fund managers said.
India will be no exception and interest rates will more or less remain at current levels, though they could climb if border tensions escalate, fund managers said.
Sentiment is crucial in financial markets which is evident in the way the debt market has moved after the September 11 incidents. In developed markets, bond prices soared as investors dumped equity in favour of debt. However, back home, even bond prices tumbled on fears that the Reserve Bank of India would hike interest rates to support the rupee. But once it became clear that a rate hike wasn't coming, bond prices rebounded to pre-September 11 levels, fund managers pointed out.
The net asset values of debt funds too have yo-yoed. The September swings have evened out, and for the quarter, debt funds just about managed to keep up with returns in the equity market. As a group, income funds (excluding monthly income plans, as many of them are invested in equity) gave a quarterly return of 1.96 per cent, gilt funds an impressive 3.57 per cent (due to the greater trading opportunities available to them, as government securities are more liquid than corporate debt) and money market funds 1.82 per cent, fund managers said.
These returns pale against their performance in the previous quarters. The grand showing in the recent past was possible because a spate of rate cuts propped up bond prices.. With each rate cut, the scope for further reduction is decreasing.
Following the last round of rate cuts on October 22, the yield on 10-year government paper is down from the pre-September 11 level of 9.10 per cent to an all-time low of 8.17 per cent, fund managers said.