The RBI move to hike cash reserve ratio (CRR) by 75 basis points is expected to increase demand for fixed income schemes which invest in short-term debt paper. With short-term interest rates expected to strengthen following the central banks move and the equity market turning volatile, investors are likely to switch to short-term debt (money market) schemes such as ultra short-term funds and liquid schemes.

Liquidity in the short term is going to be tight after RBIs move and companies advance tax outflows in March. We see demand for short-term paper, said A Balasubramanian, CEO, Birla SunLife Mutual Fund. RBI on Friday raised the cash reserve ratio the minimum cash that banks need to keep with the central bank by 75 basis points, a move that will drain out about Rs 36,000 crore from the banking system. The step is the central banks first major response to inflationary pressures that have gripped the economy.

Fund managers recommend investing in money market schemes of up to one-year maturity. Yields on the short-term paper of three months to 1-year tenure are likely to harden by 25-50 basis points over the next couple of months. Investors could use this rise in rates this to lock in higher returns in such money market schemes, said Nandkumar Surti, CIO, JP Morgan Asset Management. Money market schemes invest in instruments such as treasury bills, certificates of deposit and commercial paper, which are less susceptible to interest rate movements, unlike gilt mutual funds.

Mr Surti feels investors could wait till the Union Budget on February 26 to decide about investments in gilt funds or schemes that invest in government bonds. The government will reveal its borrowing programme for 2010-11 in the Budget, which will determine the supply of sovereign paper into the market.

If the governments borrowing programme is projected at Rs 4-4.5-lakh crore, there is a distinct possibility of the 10-year rising above 8%, Mr Surti said. The government sold bonds worth Rs 4.5-lakh crore this fiscal to finance its fiscal stimulus packages.

Higher government borrowing would result in increased supply of bonds, which will negatively impact prices and push up yields. Bond yields and prices move in opposite direction; when yields rise, prices fall and vice versa. Gilt funds trade in government bonds to benefit from the capital appreciation. But money market funds only try to capture higher yields, since the instruments are of shorter duration and lose lesser value when rates rise.

Yields on 10-year government bonds on Friday marginally rose to 7.59%, from 7.55% the previous day, despite the CRR hike. Fund managers said the rise in the benchmark paper of about 270 basis points (2.7%) in the past one year has already factored in the effect of a CRR hike.