Income funds, it appears, have got another window of opportunity to invest in the lucrative share funding system


Sep 05 - 11, 2005


During the past few years, the above average higher returns in the fixed income category of mutual funds have been due to one asset class that is COT. The weighted average return on COT investment (Badla investment in stocks) was 13.34% in '05 compared to 11.66% in '04. Since income funds have been investing to the extent of almost 70% of their fund size in COT, therefore, these funds have been able to generate higher overall returns. During the past 2-3 years, the rates of returns on other asset classes were dismally low. It's only recently (during the past six months) we have seen more than 400 bps (basis points) increase in overall interest rates.

Going forward, the critical question is whether income funds will be able to give competitive returns given the fact that mutual funds will not be able to invest in COT market anymore after the abolishment of the badla system. Now when the Badla system has been replaced with the Continuous Funding System (CFS) with effect from August 22, 2005, income funds, it appears, have got another window of opportunity to invest in the lucrative share funding system, where the rate of return is currently averaging between 16%-18%.

But this time around, it is highly unlikely that income funds would go all out for CFS investments as they did in COT. Majority of these funds are still waiting whether they should be undertaking these investments at all since there are no clear guidelines from the SECP for mutual funds regarding CFS investment. Nevertheless, income funds would have to look for other options and they just cannot be looking for share purchase financing only. In fact, they have already started increasing allocation in other areas. Major opportunities have emerged from the corporate debt (Term Finance Certificate-TFC) market. This asset class fits ideally for mutual funds, as the rate of return on most of these debt issues is on floating basis, therefore, the investors will not face the risk of price knocks in case of rising interest rates.

Currently, the yield curve in Pakistan has largely gone flat. The difference between long end (10 year) and short end (3 months) is only 1.5%, with the former offering 9.5% and latter 8.0%. This kind of situation offers little incentive to invest at the longer end of the yield curve. When short term rates are the same as long term, then why would you block your funds in long maturity bonds? Therefore, in the short to medium term, majority of the mutual funds would be aggressively investing in Treasury bills of various maturities or doing reverse repo transactions. Investment in Pakistan Investment Bonds of 3, 5 and 10 yr PIB would be a low priority as long as their rates of return are not competitive enough relating to shorter maturity instruments.

In the recent past, mutual funds have been making investment in spread transactions on the Karachi Stock exchange, which involves buying in the ready market and selling simultaneously in the futures market. The spread transactions by mutual funds have created the necessary liquidity and turnover of shares in the futures market. If the futures rules continue to allow delivery based settlement and not only cash settlement, this would give mutual funds an opportunity to deploy a part of their portfolio in this avenue.

The market for Pakistan Investment Bonds (PIBs) has become highly fragmented in the recent past. The yields on these bonds do not reflect the economic reality. Instead, the PIB market has been experiencing either extreme volatility or very little activity. Only in the past four months, we saw the 10 yr rate first rising by almost 270 bps to 11% in April, thereafter falling as low as 8.3% in July, and is now around 9.5%. These wild swings in interest rates reflect lack of depth in the market and the poor state of over-the-counter secondary market structure. During the last financial year, the government did not issue any new PIB, at the same time, following a major increase in interest rates; banks were allowed to hold their PIBs as held to maturity. With no new supply and old holdings are being kept as held to maturity, bonds trading float has shrunk substantially causing the prices to fluctuate widely. Till the time, when the supply of bonds increase and the secondary market structure is modified, the bond market is expected to remain unstable and will keep the investors away. Therefore, mutual funds are likely to avoid the PIBs market given the huge volatility. Majority of mutual funds have burnt their fingers in the PIBs market last year, when they were taken wrong footed on account of rise in interest rates. Most of them have unloaded their PIBs portfolio long time ago, however, some funds had decided to brace against the wind and retained their PIBs holdings, which they are now carrying as held to maturity in their portfolio like the way commercial banks have done it.