As the Reserve Bank of India has kept the repo rate unchanged for the third time in a row, individuals can now look at dynamic bond funds which can offer a balance between risks and returns. These are debt funds that dynamically manage their bond duration.
The fund manager actively takes a view on the future direction of interest rates and bond yields and adjusts the duration accordingly. As bonds with higher duration react the most to changes in interest rates, when the rates are expected to go down the fund manager will shift to long duration bonds. Over a longer time frame of 4-5 years, these funds can generate better returns than other thematic debt funds.
Nehal Mota, co-founder & CEO, Finnovate, a hybrid financial fitness platform, says dynamic bond funds are not so much about timing, but they work best when the rates are expected to go down. “While the timing of the rate cuts by the RBI is uncertain, the probability of rates going down over the next one to two years is more than the probability of rates going up. Hence this can be a good time to be in dynamic bonds funds for retail investors subject to two conditions. Stick to funds with a good consistent track record of delivering returns and ensure that dynamic bond funds do not cross 20% of your debt allocation to control risks,” says Mota.
Invest across durations
The idea of a dynamic bond fund is that the fund manager will change the portfolio characteristics as per the interest rate environment. Investors can remain invested for a longer period without worrying about the interest rate cycles.
Pankaj Pathak, fund manager, Fixed Income, Quantum AMC, says in the current environment dynamic bond funds do seem like a very good option for long-term fixed income allocation. “The interest rate hiking cycle has ended or near its end. Most likely, central banks will start cutting rates from next year. This would provide dynamic bonds an opportunity to generate capital gains over and above the interest accruals.”
Dynamic bond funds tend to benefit from an interest rate cycle. The fund managers have full flexibility to invest across duration —short-term, medium-term and long-term— depending on what their view is on the interest rates.
Feroze Azeez, deputy CEO, Anand Rathi Wealth, says as on date, the market view is that from here on over the medium term, bond yields could see some correction and as such dynamic bond funds have increased the portfolio duration.
“An investor can consider investing in a dynamic bond fund if he want to take advantage of the interest rate cycle,” he says. “However, one word of caution would be that investors should be ready to bear the volatility that is associated with these funds and if the interest rate call does not play out as expected then they should be willing to bear interim low return and extend the investment horizon.”
Factors to keep in mind
As dynamic bond funds take high interest rate risks, investors should be prepared for volatility in their short term performance. Investors should also be watchful of the credit and liquidity risks. They must also know what is the lowest credit quality the fund manager is allowed to go down to as this will help understand the credit risk.
Investors must look at the fund managers’ track record as dynamic bond funds are all about their discretion to allocate duration based on outlook on interest rates. “The maximum duration will help understand how much of a risk the fund manager is allowed to take. The longer the maturity the higher the risk in case of any interest rate hikes,” says Vivek Banka, co-founder, GoalTeller.
Investors must ensure that the allocation to these funds does not go beyond 20% of their debt allocation in the portfolio. Also, they must look at the tax implications as under Finance Bill 2023-24, debt funds with less than 35% in equity will be classified as other income so the taxation of such capital gains will be at the marginal rate of tax.
Ideal holding period
An ideal holding period for dynamic bond funds typically ranges from three to five years. This allows investors to potentially benefit from different interest rate cycles and the fund manager’s strategy adjustments. Longer holding period not only helps maximise returns, but also optimises returns by reducing the volatility risk. “A longer holding period also tends to mitigate the impact of short-term market volatilities, helping investors in achieving their financial objectives,” says Sonam Srivastava, founder & fund manager, Wright Research.
END OF A CYCLE
- Fund managers invest across duration —short-term, medium-term and long-term— depending on what their view is on the interest rates
- Over a time frame of 4-5 years, dynamic bond funds can generate better returns than other thematic debt funds
- Ensure that these funds do not cross 20% of your debt allocation