The liquidity withdrawal will result in pressure on very short-term rates in the immediate future and this will have consequences for long-end rates too. Inflation remains elevated, though not as high as it was three months back. But there may be concerns of a higher price level due to the potential of oil prices moving up and also due to a weaker rupee, apart from the tendency for many domestic articles of consumption, including fruits and vegetables and protein foods, to become more expensive.
While an accommodative stance may continue for an extended period of time, the market rates may move up in anticipation of tighter monetary policy and rate action. In view of this, the product preferences at this juncture should reflect three things: the expected rise in interest rates across maturities, minimising the loss of value to the lowest level possible and ensuring the credit quality of the portfolio to be of a high order, and generating a return comparable with the benchmark returns.
High Accrual Portfolios: One of the sensible things to do in a rising interest rate scenario is to invest in high accrual funds. High accrual will enable the portfolio to overcome the depreciation on account of rising yields to a large extent. This is because the rate depreciation has to move up consistently above the rate of accrual for the portfolio to register a depreciation. Therefore, accrual portfolios are preferred. At the same time, the credit quality of the portfolio should not be compromised as credit events may rise sometimes with rising cost of funds.
Arbitrage Funds: Arbitrage funds are preferred for their stable returns and tax efficiency over fixed income funds. For investments of short-term surplus of three to six months’ duration, arbitrage funds would be an ideal destination.
Fund Concentration in Shorter Maturity: To reduce the price risk or interest rate risk, the primary consideration in investments is to invest in short maturity products. While this strategy generally works well, there is yet another factor that needs to be kept in mind. The secret lies in identifying those funds which have a higher concentration of portfolio holdings with maturity within the next one year. If a significant portion of the maturities is within six months or one year, then it gives the portfolio manager the opportunity to pick up fresh investments in papers whose yield will be on the then prevailing yield curve. In other words, the re-investment will be at higher rates for this part of the portfolio. This will help push up the portfolio yield, and thereby, the portfolio returns.
Direct Bonds: Bonds at attractive yields and acceptable credit ratings could be picked up for the portfolio but those that have a maturity profile of 2 to 3 years. In recent times, the offers on some of state government enterprises have come at relatively higher yields. Dismayed by the lower returns from normal debt products, it is likely that the lure of higher yields for a lower credit may look tempting, a feeling that should be overcome with stronger resolution, mainly because as rates rise and liquidity dwindles, many companies may face pressure emanating from higher cost of debt servicing.