Fixed Income - Investment Strategy

Odds in favor

November, 2011
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Synopsis
RBI tightening is finally beginning to hit growth Depreciating rupee is setting off the benefit from falling commodity prices Higher base for Inflation to help lower inflation going forward Government to find difficult to meet deficit target of 4.6% - already priced in by the bond market Currently 10 yrs G-sec yield has shot up to ~9.00% which seems to be very close to its peak if not peaked already We expect a reversal of this trend and that yields should start falling Under the given circumstances we have devised two investment strategies that can be looked at

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Current Scenario
Inflation still close to double digits Moderating growth is raising concerns

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Inflation remains near double digits

Depreciating rupee sets off the benefit from falling commodity prices
Inflation remains sticky with no signs of price correction in any of the broad categories, i.e. primary, fuel and manufacturing Correction in global commodity prices not getting reflected in India due to depreciation of the rupee
WPI inflation remains near double digits in Oct 11
157 152 (W holesale price index) 147 142 137 132 127 122 Jul-09 Jul-10 Jan-10 Jan-11 Apr-09 Apr-10 Apr-11 Oct-09 Oct-10 Jul-11 Oct-11 12 10 (W inflation, % PI ) 8 6 4 2 0 -2

Source: RBI

WPI

WPI inflation (RHS)

21 18 15 (In tio , % fla n ) 12 9 6 3 0 -3 -6 A r-0 p 9 A r-1 p 0 Ja -1 n 0 Ja -1 n 1 A r-1 p 1 Ju 9 l-0 Ju 0 l-1 O 9 ct-0 O 0 ct-1 Ju 1 l-1 O 1 ct-1

(Non-food M anufacturing prices, index)

Food inflation stabilizing, but at higher levels

Non-food manufactured products index is flattening

137 135 133 131 129 127 125 123 Apr-10 M ay-10 Jun-10 Jul-10 Aug-10 Sep-10 O ct-10 Nov-10 Dec-10 Jan-11 Feb-11 M ar-11 Apr-11 M ay-11 Jun-11 Jul-11 Aug-11 Sep-11 O ct-11

Food
Source: RBI

Non-food
Source: RBI

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Moderating growth, rising concerns

RBI tightening is finally beginning to hit growth
Contraction of mining and high interest costs weighing down industrial production growth (1.9% in Sep 11) Eight core industries grew at their slowest in 31 months at 2.3% in Sep 11; coal, natural gas and fertilizers production contracted in September India's manufacturing activity in October expanded-though modestly--indicating an improvement in business conditions from a month ago as growth in new orders accelerated
(G th, % row )

Industrial growth at 1.9% in Sep 11

25 20 15 10 5 0 -5 -10 Jul-07 O ct-07 Jan-08 Apr-08 Jul-08 O ct-08 Jan-09 Apr-09 Jul-09 O ct-09 Jan-10 Apr-10 Jul-10 O ct-10 Jan-11 Apr-11 Jul-11
Source: GOI

IIP (wt 100)

Manufacturing (wt 75.5)

Core sector growth at the slowest in 31 months

10 8 6 4 2 0 May-10 May-11 Jan-10 Jan-11 May-09 Sep-08 Sep-09 Sep-10 Sep-11 Jan-09

Manufacturing activity expanded in Oct 11

62 (Purchasing Manager Index) 59 56 53 50 47 44 Aug-09 Jan-10 Sep-06 Jun-10 May-08 Sep-11 Dec-07 Jul-07 Nov-10 Mar-09 Apr-06 Feb-07 Apr-11 Oct-08
Contraction

(Growth, yoy,%)

Expansion

India manufacturing PMI

Source: GOI

Source: Bloomberg.

Core sector growth

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Our View
RBI to pause rate hike Markets factoring possible high Fiscal deficit

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RBI hiked the rate but hinted a pause ahead

Higher base for Inflation to come to the rescue
RBI Hiked policy rated by 25 bps in October 2011. however, at the same time it also hinted at a pause on the sharpest monetary tightening cycle We expect Inflation to be at current levels in Oct-Nov 11 and to fall sharply to ~8% in Dec11-Jan12, due to a strong favorable base. Our Mar12 inflation target is ~7.5%
Sharpest monetary tightening in any tightening cycle
9 (P lic ra ,% o y te ) 8 7 6 5 4 O t-0 c 5 Fb 6 e -0 Jn 6 u -0 O t-0 c 6 Fb 7 e -0 Jn 7 u -0 O t-0 c 7 Fb 8 e -0 Jn 8 u -0 O t-0 c 8 Fb 9 e -0 Jn 9 u -0 O t-0 c 9 Fb 0 e -1 Jn 0 u -1 O t-1 c 0 Fb 1 e -1 Jn 1 u -1 O t-1 c 1 Reverse Repo
Source: RBI

Repo Rate

Inflation likely to soften to 7-7.5% by Mar 12

12 10 (In tio , % fla n ) 8 6 4 2 0 A r-0 p 5 O t-0 c 5 A r-0 p 6 O t-0 c 6 A r-0 p 7 O t-0 c 7 A r-0 p 8 O t-0 c 8 A r-0 p 9 O t-0 c 9 A r-1 p 0 O t-1 c 0 A r-1 p 1 O t-1 c 1 A r-1 p 2 -2

Reducing gap between core inflation and repo rate

W inflation PI
Source: RBI

Estimates
Source: RBI

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Markets factoring possible high Fiscal deficit

Difficult to meet deficit target of 4.6%
Fiscal deficit at 71% of FY12 target in first half of FY12

In first half of FY12, fiscal deficit has already reached 71% of the budget target for the full year FY12 Target of 4.6% budget deficit seems too challenging to meet as the slowdown would affect revenues Government may have to borrow additional Rs 500bn to meet the shortfall from the revenue side; bond market already factoring in the slippage on the fiscal front Historically, government usually spends more in the first half while revenues pick up in second half
Expectations of more govt. borrowing pushed the yields ~9%
10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 Jul-11 O ct-08 O ct-09 O ct-10 Jan-09 Jan-10 Jan-11 Apr-08 Apr-09 Apr-10 Apr-11 O ct-11 Jul-08 Jul-09 Jul-10

Revenue deficit Fiscal deficit Expenditure Non-tax revenue Net tax revenue 0 10 20

27.8 33.2 47.6 44.2 40.5

76.0 70.8

74.9 36.6 41.4 30 40 50 60 70 80

(% of full year target)

Source: GOI

1HFY11

1HFY12

Corporate tax remains a laggard

1,400 1,200 1,000 (Rs bn) 800 600 400 200 0 Income tax
Source: GOI

(10 year g-sec yield, % )

Corporate tax 1HFY11

Custom duties 1HFY12

Excise duties

Source: Bloomberg and Anand Rathi Research.

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Investment Opportunity
Strategy 1: Capital Gains Strategy 2: Interest Accrual

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(-) Return (+)

Strategy 1 Capital Gains

(-) Risk (+)

10 Yr Benchmark G-Sec is at peak levels Investment Rationale

We expect inflation to decline to ~7.5% by Mar12 on account of higher base and the impact of monetary tightening getting reflected in the system If growth remains sluggish RBI might consider a rate cut around Q1 of FY13 Also, any collapse of the financial system in the Euro zone would result in reserve banks cutting down policy rates to keep economies afloat From all the above we expect 10 Year benchmark G-sec rates to peak out at ~9.25% and then start softening towards its historical mean (~7.50% - 8.00%)

Recommendation
The rallies in G-sec markets can be sharp and can come very rapidly. Since 2002 we have seen that the 10 Year benchmark G-sec has spent more time below YTM of 7% than above 9%. Moreover, it is difficult to time the market and catch the peak. We suggest investors looking for a medium risk - high return^ opportunity to start allocating a portion of their debt portfolio towards G-Sec funds in a staggered manner over a 2-3 month period, with an investment horizon of 12-15 months
^ Refer appendix - Reading the risk-return grid
738 Days 202 Days 50 Days

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Strategy 1 - Gilt Funds - Actively Managed

Top 5 picks
Scheme Name Kotak Gilt Investment ICICI Pru Gilt-Invest PF(G) Birla SL G-Sec-LT(G) HDFC Gilt-LT(G) UTI Gilt Adv-LTP PF(G) Age (yrs) 12.28 12.22 11.98 10.29 9.78 AUM Crs 45.80 221.18* 381.72* 160.46* 125.76* 1M 3.39 (10.72) (6.67) (12.65) (15.04) 3M 7.58 (0.79) (0.15) (2.20) (1.16) 6M 6.52 2.57 2.85 2.00 3.90 1YR 5.34 3.72 3.74 3.16 5.21 2YR 5.65 3.91 6.87 4.34 4.84 3YR 9.05 6.61 11.77 4.88 4.95 Avg Mat (Yrs) 10.00 7.00 7.50 8.60 7.35 Cash (%) N.A. 31.33 23.47 5.77 34.22 Duration 6.50 4.70 5.35 5.00 5.25

Note: Funds with AUM more than Rs.40crores are only selected Funds with a track record of more than 3 years Data Source: ACE MF and AMCs * as on Sep-11

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Strategy 1 - Gilt Funds - Passively Managed

Motilal Oswal MOSt 10yr Gilt Fund Fund Details
Type of the scheme: An Open Ended Gilt Scheme Two Plans: Dividend & Growth Fund Manager: Abhiroop Mukherjee B.com (H), MBA 4yrs Experience in Trading Fixed Income Securities viz. G-Sec, T-bills, Corporate Bonds CP, CD etc. Earlier worked with PNB GILTS LTD. as WDM dealer for 2007-2011 Total Expenses: 0.99% Exit Load: 0.5% if redeemed within 3 months Min Subscription: Rs.10,000 & in multiples of Re. 1 thereafter NFO Opens: 21st November 2011 NFO Closes: 5th December 2011
Note: For further details, please refer to the Scheme Information Document (SID)

Asset Allocation
Security 10 Year Benchmark G-Sec Other Government Securities (7 to 12 years), T-Bills, Cash Management Bills, CBLO & Repo Investment 90 100 % 0 10 %

Investment Rationale
Replicates the 10 year G-Sec benchmark returns Defined mandate of the fund High Liquidity and denominations can be smaller Good investment for investors willing to take a call on government securities

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(-) Return (+)

Strategy 2 Interest Accrual

(-) Risk (+)

Flat Yield Curve, good accruals on short term

Existing yield curve is flat. It is in a very narrow range of 8.50% - 9.00% This makes the accruals on the shorter end of the yield curve attractive as compared to the longer end If the yield curve starts becoming normal again, there is some scope for capital gains. However, due to low duration on the short-end, either capital gain or loss will be negligible over small movements in yields We suggest our clients to invest in Short-term income funds with an investment horizon of 3-6 months
Yield Yield

9.00 8.50 8.00 7.50 7.00 3-Nov-2011 6.50 3 Months 6 Months 2 year 10 Year 11 Year 12 Year 13 Year 13 Year 14 Year 14 Year 1 Year 3 Year 4 Year 5 Year 6 Year 7 Year

Current Scenario: Flattish yield curve

Tenure

9.00 8.50 8.00 7.50 7.00 6.50 3 Months 6 Months 2 year 1 Year 3-Nov-2010 3 Year 4 Year 5 Year 6 Year 7 Year 3-Nov-2008 10 Year 11 Year 12 Year

Past Scenario: Normal yield curve

Tenure

Note: for Maturities where data was not available Yield has been assumed to be average yield of the immediate next and previous maturities available ^ Refer appendix - Reading the risk-return grid

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Strategy 2 Short-Term Bond Funds

Top 5 picks
Age (yrs) 9.52 8.36 Avg Mat Yield to (Yrs) Maturity 1.50 2.34 0.80 1.00 1.68 10.10 9.75 9.98* 10.17 9.92*

Scheme Name

AUM Crs

1M

3M

6M

1YR

2YR

3YR

AAA/P+

Cash

Kotak Bond-STP(G) UTI ST Income(G) Templeton India ST Income(G) DWS Short Maturity-Reg(G) ICICI Pru STP-Ret(G)

980.08 223.25*

6.69 7.61 8.51 7.66 8.23

7.58 8.47 8.84 8.90 8.61

8.68 9.54 9.39 9.28 9.02

6.65 8.83 8.16 7.90 7.54

5.86 7.43 7.40 6.68 6.20

8.48 8.06 9.52 9.38 9.25

81.99 51.60 64.72 70.40 63.63

4.83 3.88 1.43 4.54 3.75

9.76 4415.59* 8.78 10.02 575.34* 652.59*

Note: Funds with AUM more than Rs.200crores are only selected Funds with a track record of more than 3 years Data Source: ACE MF and AMCs * as on Sep-11

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Appendix
Glossary Tax Reckoner Risk-return grid

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Key Terms Glossary

The Yield to maturity (YTM) of a bond or other fixed interest security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. Yield to maturity is actually an estimation of future return, as the rate at which coupon payments can be reinvested when received. The duration of a financial asset that consists of fixed cash flows; It is the weighted average of the times until those fixed cash flows are received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields Modified Duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates

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Tax Reckoner 2011-2012

Individual/ HUF Domestic Company NRI* Tax Implications on Dividend received by Unitholders Dividend Equity oriented schemes Nil Nil Nil Debt oriented schemes Nil Nil Nil Tax on distributed income (payable by the scheme) rates effective from 1st June 2011 Equity oriented schemes ** Nil Nil Nil 12.5% + 5% Surcharge + 3% 30% + 5% Surcharge + 3% 12.5% + 5% Surcharge + 3% Debt schemes Cess= 13.519% Cess = 32.445% Cess= 13.519% 25% + 5% Surcharge + 3% 30% + 5% Surcharge + 3% 25% + 5% Surcharge + 3% Money market and Liquid schemes Cess= 27.038% Cess = 32.445% Cess= 27.038% Capital Gains Taxation Long Term Capital Gains (Units held for more than 12 months) Equity oriented schemes ** Nil Nil Nil 10% without indexation or 10% without indexation or 10% without indexation or 20% with indexation Other than equity oriented schemes 20% with indexation 20% with indexation whichever is lower + 3% Cess whichever is lower + 3% Cess whichever is lower + 3% Cess + 5% Surcharge Without indexation 10.3000% 10.8150% 10.3000% With indexation 20.6000% 21.6300% 20.6000% Short Term Capital Gains (Units held for 12 months or less) 15% +5% Surcharge + 3% Cess Equity oriented schemes ** 15% + 3% Cess = 15.45% 15% + 3% Cess = 15.45% = 16.223% 30% +5% Surcharge + 3% Cess Other than equity oriented schemes 30% + 3% Cess^ = 30.9% 30% + 3% Cess^ = 30.9% = 32.445%
*The short term/long term capital gain tax will be deducted at the time of redemption of units in case of NRI investors only. ** STT @ 0.25% will be deducted on equity funds at the time of redemption and switch to the other schemes. Mutual Fund would also pay securities transaction tax wherever applicable on the securities bought / sold ^ Assuming the investor falls into highest tax bracket.

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Reading the Risk-Return grid

(-) Risk (+) (-) Return (+) (-) Risk (+) (-) Return (+) (-) Risk (+) (-) Return (+) (-) Risk (+) (-) Return (+) (-) Return (+) (-) Risk (+) (-) Return (+) (-) Return (+)

Low Risk, High Return

(-) Risk (+)

Average Risk, High Return

High Risk, High Return

(-) Risk (+) (-) Return (+)

Low Risk, Average Return

(-) Risk (+)

Average Risk, Average Return

High Risk, Average Return

(-) Risk (+) (-) Return (+)

Low Risk, Low Return

Average Risk, Low Return

High Risk, Low Return

Note: 1. Risk & return assessment based on qualitative analysis 2. Risk & Return are relative to the Asset Class

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Reading the Risk-Return grid

Average Annual Rate of Return

Sectoral Equity Funds Diversified Equity Funds Balanced Funds MIPs Gilt/Income Funds Short Term Bond Funds Money market Funds

Risk (Standard Deviation)

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Thank you

Disclaimer:-This report has been issued by Anand Rathi Financial Services Limited (ARFSL), which is regulated by SEBI. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). ARFSL and its affiliates may trade for their own accounts as market maker / jobber and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. ARFSL, its affiliates, directors, officers, and employees may have a long or short position in any securities of this issuer(s) or in related investments. ARFSL or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report. This research report is prepared for private circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report.

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