Tuesday, November 07, 2006

Review of Principal Income Fund STP Mutual fund


Principal Income Fund — Short Term Plan has delivered an annualised return of 7.9% in the last three months ended October 31. In comparison, the CRISIL Short Term Bond Index, against which the fund is benchmarked, delivered a return of 7.25%.

The short-term fund category gave an average return of 7% during the period.

Capital gains from G-secs and corporate bonds helped the fund deliver. Government bonds rallied on the back of lower US bond yields and a fall in energy prices. Also, yields on corporate bonds in the 2-3 year segment eased. One-year AAA-rated corporate paper rates fell to around 7.7% per annum from 8%-plus per annum levels in the last quarter.

Since the fund was able to anticipate this in advance, the fund’s three-month performance has been good and the corpus has swelled as a result.

In the one-year returns also the fund has outperformed the benchmark by quite a distance. The fund gave a return of 6.1%, while the benchmark returns was 4.8%. The category of short-term funds gave returns of 5.8%.
Portfolio

As per available data, the corpus of the fund as of October 31, ’06 was Rs 1,365.85 crore. Over 65% of this amount was invested in commercial papers of banks. Most of these instruments carried the P1+ rating denoting ‘very strong’ credit quality of these instruments.

The fund has also invested in corporate bonds to the extent of 24.5%. If credit off-take moderates, corporate sector issuances may come down. This could further reduce corporate spreads (difference between corporate bond yields and government securities) over the medium term.

One-year corporate papers are attractive from a carry perspective. If the yield curve flattens, the one-year bonds will lose attractiveness. The fund will have to shuffle to maintain returns.

It has taken full advantage of the bond rally to enhance returns in the last quarter. The fund has reduced long positions to moderate levels as the fund manager does not see an immediate upside in the curve. Going ahead, the fund is looking at investing in G-secs as the inflationary scenario is milder than before.

Principal STP is quite bullish on the one-year maturity. This offers investors an opportunity to
earn decent spreads over money market rates and also ensure higher capital gains if they hold for 3-6 months.

The fund, typically, buys into longer duration paper and earns higher interest rates; as the holding period falls, the fund earns capital gains accruing from the lower yields. This is because after 3-6 months, the one-year paper becomes a nine-month or six-month paper, which attracts lower yields.

However, with RBI hiking rates, though higher interest rates are still possible, capital gains accrual seems unlikely.

Investors looking to park short-term funds can consider this option as it is expected to generate higher returns than cash fund in a benign interest rate environment with 2-3 month investment horizon. Investments should be made with a time horizon of 3-6 months.

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