HEDGING RISKS
Floating Rate Assets Under Management
DSP Mutual Fund	198
Birla Sunlife Mutual Fund	190
Tata Mutual Fund	200
HDFC Mutual Fund	83
Kotak Mutual Fund	202
Figures in Rs crore

Indian interest rates have been on a decline for three years and more, and debt fund investors have enjoyed marvellous double-digit returns as a result. This is because falling rates go with rising secondary market prices of earlier-issued bonds-the scramble for which raises their market value as tradable assets (and lowers their yield).

After a long season of rising assets, it's time now to face reality. Already, some smiles in the debt market have turned to frowns; the past few months have seen some debt funds generate negative returns for a change. If this is shocking enough, worse could yet come.

So if you're wondering if you could lose your shirt in the supposed safety of the debt market as well, you're reading the right thing.

Worry Addressal

Well, could you? If you want an instant answer to the question, it's 'yes' and 'no'. Yes, because it has actually happened over the last few return periods for some funds. No, because the returns can be recovered by lengthening the investment horizon.

Hear out Sandesh Kirkire, Senior Vice President and Head, (Fixed income security investments), Kotak Mahindra Mutual Fund. "One would generally not lose capital in debt funds unless there is a credit default," he says, "which is unlikely in portfolios that are invested in government securities and highly rated corporate debt." According to him, the 'loss of capital', as some debt funds have generated lately, happens only for short periods of time. So if you are a debt fund investor, just holding on for longer would be enough.

Still, if you're allergic to risk, as most debt investors are, what should be your investment strategy? Can you hedge your bet some way or the other?

Some Directions

Debt investment is no simple affair involving the loaning of money at a prefixed rate of interest. It involves secondary market transactions, and this makes it almost as dynamic as the stock market. The obvious way to begin any formulation of a debt investment strategy is to examine the direction of interest rates.

In the old days of heavy government intervention, banking inefficiency meant that money deposited at low rates needed to be lent at high rates, and economic rigidities meant that inflation was always a threat. The double whammy's outcome? High lending rates. In any case, even if those conditions were changing, rates remained unresponsive because they were state-controlled more than market-set.

Over the 1990s' reforms, as the financial system was partly freed and exposed to competition, efficiency rose and inflation-after threatening to break out during the mid-1990s' boom-stabilised somewhat, making space for lower rates.

That's the structural story. The confusion arises from subsequent changes in the demand and supply of funds, the interaction of which gives us the rates in a market system. The recent recession saw a drop in both inflation and credit demand, resulting in rates falling even lower than they otherwise would have (on account of just market efficiency). This, broadly, is the period in which debt fund investors made so much money.

But the reality is that rates cannot fall forever. Even under a bout of self-sacrificing banking generosity, the rates cannot, as a limit, fall below inflation. And a "potentially inflationary economy" is something even lay investors are talking about. Moreover, any significant pickup in economic activity ought to spur credit demand, resulting in a sharp reversal of the rates' direction.

So, are bond markets nervous? Are rates rising? A little bit. "While minor corrections can't be ruled out, interest rates would continue to be on the softer side over short term," opines K.G. Bhandari, Head of risk management, Indus Ind Bank. Likewise, all that Satyavrat Mohanty, Fund Manager (Debt Segment), Birla Sunlife Mutual Fund, is willing to accept is that interest rates are "almost bottoming out at this point in time".

The reason bond prices have not tumbled and rates are not rising much is that the economy is still suffering from a 'liquidity overhang', bankspeak for cash still hanging around undeployed. Besides, the Reserve Bank of India (RBI) is still the primary rate-setter, and is unlikely to upset the Government's borrowing programme.

Last reported, though, the RBI was set to issue bonds of its own (another category of sovereign debt) to suck out liquidity produced by its own dollar-buying activities to keep the rupee from appreciating too much. The size of this 'stabilisation' programme, at over Rs 40,000 crore, is said to be staggering. Rarely has the Indian debt market been flooded this way with so many bonds.

It all adds up to the message that expecting rates to remain stable well into the summer of 2004 would be foolish.

Bankers, meanwhile, are watching other sets of variables as well. They know they must always be prepared for a surge of credit demand-in case the incipient economic revival is sustained. "If the economy continues to grow at 7-8 per cent over the next few years," says Ved Prakash Chaturvedi, CEO, Tata Mutual Fund, "the demand for credit and investments will rise significantly, resulting in interest rate inching up, as interest is nothing but the cost of money." Then again, you can't really be too sure.

Float Hedge

So, what we have is short-term stability in rates, and uncertainty beyond that. The good news is that you can hedge your risk by allocating a part of your debt portfolio to floating rate debt product.

If you switched from a fixed rate home loan to a floating rate one just to keep your interest risk exposure in line with the market rate, you'll identify with this idea. "A floating rate fund is apt for debt investors in a market where there is uncertainty in interest rates," says Chaturvedi.

Floating rate funds are a low-risk option, and aim to make at least 65 per cent of their investment in floating rate debt of some sort or the other. Modern instruments could be used, such as swaps of fixed rate payments for floating rate payments. Of course, some part of the portfolio is composed of regular fixed-rate debt-money market instruments and the like.

In all, says Mohanty, "An exposure to floating rate funds reduces the interest rate volatility." Unless you have a clear picture of circumstances ahead, a floating fund might be exactly what you need.

Spare it some thought.

Quarterly Dividends

A few firms have started paying quarterly dividends to investors. Could the trend catch on?

By Narendra Nathan

Centuries since the first game pie was divided up, dividend play is poorly understood by people at large and well-understood by strategists. It helps corporates juggle tax liabilities, alter the return-on-net-worth figure, and secure investor support. In Japan, it even deters hostile takeovers. But what's with the quarterly wave?

It's a barely emergent trend, but the names involved are Reliance Energy and HCL Technologies. No lazy thinkers, these two. Or maybe it's just a matter of convenience. "As all companies now have to make quarterly profit-and-loss accounts and balance sheets," says Kaushal Shah, Analyst, LKP Securities, "they have started distributing dividend as well."

If something sounds a little too obvious, ask if there are other factors in play too. And indeed, there are. Thanks to the Finance Act 2003, dividends from equity shares have become tax-free in the hands of investors. With this, investor focus-particularly of high networth individuals-has shifted to high dividend-yield companies. The clamour now is for companies, even growth-industry ones, to give out the cash made rather than reinvest it for growth.

The dividend pay-out ratio (dividend outgo as a percentage of net profit) of HCL Technologies has gone up from 8 per cent three years back to 60 per cent now. Ask the company, and you will hear of interest rate stabilisation. Elaborates S.L. Narayanan, Corporate VP (Finance), HCL, "With interest rates stabilising and reduced opportunities for gains on treasury income, there is no reason for us to hold on to the surplus. So we have started increasing our payout ratios to rightsize the balance sheet. Let the shareholders get their money back and invest it according to their risk appetite."

By virtue of the salience they get in investor mindspace, quarterly payouts act as a signal of a company's confidence in future profits. So the markets like it all the more. In animal spirit terms, it's the sound of money gushing along. Of course, the quarterly dividend must not be a token sum. On this, HCL's dividend (100 per cent of face value) is significantly stronger than that of Reliance Energy (10 per cent).

But then, as Sumeet Mehta, Analyst, IDBI Capital Markets, explains, "The investors at Reliance Energy now are investing for growth and not for dividends. The quarterly dividend yield would work out to be very small." Indeed, Reliance Energy's dividend of Re 1 on a market price of Rs 742 per share amounts to a mere 13 basis points-not much of a boost for dividend yield.

For small shareholders, the cheque may actually be too small to bother claiming. So why bother with a quarterly dividend? Surely, sending four dividend warrants a year involves higher transaction costs. "Administrative costs have indeed gone up," admits HCL's Narayanan, "But that is a small price to pay for improving the attractiveness of the HCL Tech stock."

That's a rationale, sure. But something tells us there's something in the air as well. Maybe it is what Shah is suggesting-part of the quarter-to-quarter mindset that seems to have overtaken everybody in the financial world. While a year used to be the assumed 'unit' for all mental measurement once, it has started becoming a quarter. Whatever it is, the quarter-by-quarter game is unnerving those who remain steadfastly dedicated to analysis as a whole.