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Riding The Credit Wave

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In stocks, potential positive and negative returns are symmetrical; with bonds, the upside is a fraction of the amount invested while the downside is default. Which calls for a great degree of conservatism and good risk management, including credit risk management.
So, rather than timing the market, Santosh Kamath, senior vice-president and chief investment officer of fixed income at Franklin Templeton Asset Management, focuses on what to buy. "While most may focus on interest rate risk, for us the focus is what to buy," he says.
The result? His fund, Templeton India Short-Term Income Institutional Plan wins the Businessworld-Value Research Best Mutual Fund award in the short-term category. "We played the credit spread extremely well when it went up. This made all the difference," says Kamath. 

Following the global credit crisis of 2008, when investors became very risk-averse, and credit spreads for genuinely good credit moved up sharply, Kamath saw an opportunity in betting on pass-through certificates (PTCs) — securities or paper issued against future payments on mortgages, credit cards, car loans or other regular receivables. "At that time, PTC spreads were higher than on normal paper. Markets perceived the risk on a PTC being much higher than it was. We saw high yield, low downside risk." He remembers Tata Motor Finance, Cholamandalam Finance and Citi Financial as three good picks. H had got PTCs that paid a spread of 250-300 basis points (bps) more than their actual prices. 
The other reason for good returns is low credit risk. "Neither do we have any real estate paper in our portfolio, nor do we have government securities (G-Secs)," says Kamath. "If you get it right, you make money; if not you lose heavily." 

He outperformed on three fronts. First, the fund bought high-yield, short-term corporate bonds that returned 12-13 per cent on maturity of close to a year. Second, no G-Secs as they expected rates to move up. Finally, the spread on PTCs came down by 300-400 bps, giving the fund a hefty capital appreciation.

Top 3 Debt: Short-term 
1 Templeton India Short-term Income Inst. 7.34%*
2 UTI Short-term Income Inst. 6.61%*
3 Canara Robeco Short Term Inst. 5.32%*
*18-month returns 

The fund Kamath manages has over Rs 5,000 crore in assets under management (AUM) — one of the largest in the category. The Institutional Fund's AUM is Rs 1,400 crore. It reported a 7.34 per cent return, nearly 75 bps higher than the second best, UTI Short-Term Institutional Fund (6.61 per cent).

But for the past three months, the fund has underperformed the market: short-term interest rates have risen sharply, affecting the fund's marked-to-market portfolio. But Kamath feels short-term rates are near their peak (which might change if the RBI raises policy rates). "It may go up by another 25 bps; investors can come in now and book a good capital appreciation once interest rates decline."

Portfolio composition in December 2010 was 40 per cent corporate debt, 25 per cent certificates of deposit (CDs), 15 per cent in pool PTC and 18 per cent in a single-loan PTC. Next year, "the game will still be the credit spread", says Kamath. "If spreads are high, we will buy corporate bonds; if they are low, we will buy bank CDs. If even those get too low, we will buy one-year treasury-bills." Short and simple.


(This story was published in Businessworld Issue Dated 28-03-2011)