All You need to Know About Dynamic Bond Funds

Posted On Thursday, May 18, 2023


Did you know that bond prices and interest rates are interlinked? Various macroeconomic factors such as government borrowing, central bank's objective, and inflation impact the movement of interest rates, thereby affecting the bond prices. When the yields move up, prices of bonds go down and therefore, debt mutual funds, especially those holding longer maturity instruments, witness diminishing returns. Similarly, when interest rates fall, bond prices move up and so do the returns on your debt mutual fund.

Thus, the returns on debt mutual funds are not fixed and are affected by the movement in interest rates. Creating a debt portfolio that works well regardless of the interest rate cycle can be a challenging task if you do not understand interest rate movement. To ensure that you earn optimal returns during both rising and falling interest rate scenarios, you may consider investing in a Dynamic Bond Fund.

Unlike other debt mutual fund categories that follow a pre-determined portfolio duration and hold the instruments till maturity, Dynamic Bond Funds have the flexibility to shift investments between short-term and long-term bonds based on the interest rate environment.

What are Dynamic Bond Funds?

According to SEBI categorisation norms, dynamic bond funds are open-ended dynamic debt schemes that invest across duration. These funds have the flexibility to invest in short-term instruments, such as commercial paper (CP) and certificates of deposit (CD), or medium to long-term instruments, such as corporate bonds and gilt securities.

The investment objective of a Dynamic Bond Fund usually is to generate income and capital appreciation through active management of a portfolio consisting of short-term and long-term debt and money market instruments.

When the interest rates are falling, long-term instruments tend to perform well, while in the rising interest rate scenario, short-term instruments tend to perform better. So, if a dynamic bond fund anticipates an escalating interest rate scenario, it will increase holdings to short-term instruments and vice versa. Thus Dynamic Bond Funds, taking a view of the interest rate cycle and undercurrent in the debt market, are actively managed.

Why consider investing in a Dynamic Bond Fund?

Regardless of the direction interest rates move, Dynamic Bond Funds are capable of taking advantage of dynamic market conditions and can invest accordingly to create an all-season portfolio and generate attractive returns.

As mentioned earlier, Dynamic Bond Funds invest across duration - short-term, medium-term and long-term - depending on where interest rates are headed. Thus, a Dynamic Bond Fund holds the flexibility to adjust the duration of the portfolio to benefit from the possible change in the interest rate scenario.

If interest rates are anticipated to increase, Dynamic Bond Funds allocate a higher portion of their portfolio in low duration bonds and re-invest the proceeds at a higher rate. Conversely, if interest rates are expected to fall, Dynamic Bond Funds invest in long-term bonds to benefit from the subsequent rally in bond prices. Therefore, a Dynamic Bond Fund could typically hold short-term instruments, such as commercial papers (CP) and certificates of deposit (CDs), and/or long-term instruments, such as corporate bonds and gilt securities, depending on the interest rate outlook.

Here are three key benefits of investing in a Dynamic Bond Fund…

  1. Reduces interest rate risk through active management of portfolio based on interest rate outlook;
  2. No need to time the entry and exit in the debt market because fund managers take care of it;
  3. Offers a solution for your long-term debt investment needs;

That being said, do note that the performance of a Dynamic Bond Fund largely depends on the fund manager's judgement of the interest rate movement. If the manager fails to gauge the movement of interest rates accurately or is unable to time the investment precisely, investors may suffer losses.

Additionally, the recent crisis in the corporate bond segment has made debt funds with higher exposure to private issuers vulnerable to credit risk, and it may not be considered a safe bet for conservative investors.

Therefore, it is important to invest in a Dynamic Bond Fund with a well-diversified portfolio of securities, a dynamic maturity profile, and high-quality debt & money market instruments (predominantly government securities).

Who should invest in a Dynamic Bond Fund?

Dynamic Bond Funds are sensitive to interest rate changes and thus may witness some volatility, typically in a rising interest rate scenario. However, the impact of such fluctuation may fade out over a period.

On the risk-return spectrum of debt funds, a Dynamic Bond Fund is placed slightly on the higher end of the risk-reward spectrum – between Medium Duration and Long Duration Debt Fund. This makes Dynamic Bond Funds suitable for investors with an investment time horizon of at least 3 to 5 years with an appetite to bear short-term volatility.

Pay attention to the following parameters to pick the best Dynamic Bond Fund:

  • The portfolio characteristics of the scheme
  • The average maturity profile
  • The expense ratio of the scheme
  • The rolling returns
  • The risk ratios
  • The performance across interest rate cycles
  • The investment processes & systems at the fund house

Lastly, do not assume that investments in debt mutual funds are safe or risk-free, there are various risks involved, such as interest rate risk, credit risk, liquidity risk, etc. Therefore, it is important to invest in debt schemesthat align with your risk appetite, investment horizon, and investment objective.

Happy Investing!

Disclaimer, Statutory Details & Risk Factors:

The views expressed here in this article / video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of this article should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments.

Mutual fund investments are subject to market risks read all scheme related documents carefully.

Above article is authored by Quantum.

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