The Reserve Bank of India (RBI), in the last monetary policy review in April 2012, surprised the markets with a 50 basis points repo rate cut, vis à-vis market expectations of 25 basis points. RBI's announcement came in the backdrop of falling core inflation data and tepid economic growth. The fiscal deficit target of 5.1 per cent for FY13, though lower than FY12, could be a big challenge for the government to achieve, on account of limited pass-through of higher oil prices to end users and slippages in revenue collections. Any slippage in deficit is likely to lead to higher government borrowings, which could not only put pressure on yields but also pose a threat to growth by crowding out private investments.

In the near term, we see limited scope of further monetary easing in the coming months on account of factors, such as an elevated crude oil price, an inflationary budget and weak rupee, all of which pose upside risks to inflation. In the medium term, we could be looking at an aggregate repo rate cut of 100 basis points in FY13, of which 50 basis points has already been front-ended, along with some measures to address the liquidity deficit in the system. We hold the view that if India's gross domestic product (GDP) growth rate continues to be below trend, we could see inflation declining further and give some room to RBI to initiate further rate cuts in the latter half of FY13.

We believe that short-term income funds, which have an average maturity of two to three years, will do well for investors in the current scenario. While the yield curve has steepened mildly post-rate cut in April, further steps to ease liquidity and falling inflation are expected to lead to decline in short-term rates and steepen the curve further over the next 12 to 15 months. In such a scenario, short-term income funds can outperform the ultra-short and liquid funds.

In the longer end, government securities' (G-Sec) yields are likely to be range-bound. While the supply pressure, accompanied with limited scope of monetary easing, could put a floor to yields, the magnitude of Open Market Operations (OMO) could potentially put a cap on yields. Since we are not expected to see a steady decline in G-Sec yields, funds which will be actively and dynamically managed, can gain from the market opportunities. Such funds have the flexibility to invest across fixed income assets and can be looked at with a medium-term horizon of 18 months and above.