Investing in dynamic bond funds can help individuals optimise returns across varying phases of the interest rate cycle. These funds have the flexibility to invest in both short-term and long-term bonds, depending on the fund manager’s assessment of the interest rate scenario.
Predicting interest rate movements is a complex and nuanced process, even for seasoned investors. So, by investing in these funds, retail investors can benefit from the insights and strategies of experienced fund managers and reduce the risk involved in direct bond investments. The top performing funds such as Bandhan Dynamic Bond Fund and DSP Strategic Bond Fund have yielded 10.9% and 10.5%, respectively in the last one year. The average one-year returns of this category is 9.5%.
“Dynamic bond funds are better positioned now, as they offer fund managers the flexibility to adjust the portfolio’s risk level—making it more aggressive or defensive—based on the prevailing market conditions,” says Pankaj Pathak, fund manager, Fixed Income, Quantum AMC.
Since dynamic bond funds can take on higher interest rate risk, investors should consider a holding period of at least three years or more. This time-frame allows investors to navigate short-term interest rate volatility effectively while leveraging the fund manager’s active duration management to maximise returns.
Expectations of a rate cut
From a returns perspective, dynamic bond funds offer higher potential, particularly in a declining interest rate environment, as they can capitalise on bond price appreciation. These funds also eliminate the reinvestment risk, which is a challenge with bank deposits, especially when interest rates fall.
As expectations for rate cuts grow, many dynamic bond funds have already begun increasing the average maturity of their portfolios. The category’s average maturity has nearly doubled, rising from around seven years in October last year to 15 years now. “This proactive adjustment underscores the responsiveness of dynamic bond funds to evolving rate expectations, making them a compelling choice for investors navigating an uncertain rate cycle,” says Nirav Karkera, head, Research, Fisdom.
Tax advantage
In terms of taxation, debt mutual funds still offer a tax advantage over fixed deposits, even if both are subject to the same marginal tax rate. With fixed deposits, investors are taxed on the interest income earned each year. However, with debt mutual funds, tax is only applied when the investment is redeemed. By holding the investment for a longer period, investors can defer the tax liability and minimise the negative tax impact on their returns through compounding.
Compared to bank deposits, dynamic bond funds can offer 1-2% higher returns, provided the fund manager times the market effectively and invests in high-credit-quality instruments. “While both options are now taxed at the marginal rate, the potential for higher returns makes dynamic bond funds an attractive alternative for those with a medium-term investment horizon,” says Soumya Sarkar, co-founder, Wealth Redefine, an AMFI registered mutual fund distributor.
While dynamic bond funds may not match the performance of long-term funds in a sustained rate-cutting cycle, they offer risk mitigation. Those with medium-term goals should consider these funds to safeguard against unexpected delays in rate adjustments. “Given the higher maturity profile of dynamic bond funds, they are not recommended for short-term investments unless the investor has a clear understanding of the risks involved and is prepared to navigate potential market fluctuations,” says Sachin Jain, managing partner, Scripbox.