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Dynamic Bond Funds- Meaning, benefits and limitations, features

dynamic bond funds
dynamic bond funds

Introduction

Dynamic bond mutual funds are open ended debt mutual funds which can invest in securities across durations. Their portfolio is quite flexible when compared to other debt funds. The fund’s performance depends on the fund manager’s expectation on the market and interest rates. Any wrong call can affect the fund’s performance adversely. Hence these funds are considered as moderate risk funds and do not suit conservative investors.

What are dynamic bond funds?

SEBI defines dynamic bond funds as open-ended debt mutual funds that invest across duration. They follow a dynamic approach in terms of the maturity of securities in the portfolio. One of the main objectives of dynamic bond funds is to provide optimal returns in both falling and rising interest rate scenarios.

These funds shift the duration of the fund based on market scenarios. In a market scenario with falling interest rates, the fund might invest for a long duration. While, during a rising interest rate scenario, the funds invest in short duration funds.

Thus, the fund’s performance entirely depends on the portfolio manager of the fund house. The role of the fund manager is very crucial in dynamic bond mutual funds. His/her view about the market and interest rate can fetch good returns for the funds. However, the tables can turn another way too. If their call goes wrong, the dynamic debt fund can have huge losses.

During uncertain situations, the trends in interest rates are not noticeable. The interest rates might go up or down sharply, and dynamic funds might take a hit. This is the biggest risk in these funds.

Dynamic funds are taxed like any other debt fund. Short term capital gains (if redeemed within three years from the date of investment) are taxed at individual income tax slab rates. While long term capital gains (if redeemed after three years from the date of investment) are taxed at 20% with indexation benefit.

How dynamic bond funds work?

The very nature of dynamic bond funds enables them to instantly switch between long term, mid term and short term securities. For example, in a scenario where the interest rates are about to fall, the fund manager can increase the tenure. In contrast, if the fund manager thinks that the interest rates have hit rock bottom and there is no scope for them to fall further, then he would reduce the tenure of the portfolio. In other words, the portfolio manager can address the risk of capital losses on long term bonds by reducing the portfolio’s average maturity.

The expectations in the change in interest rates guide the fund manager to trade bonds of varying maturities. In bond funds, the fund manager can increase holding in the medium term and short term securities while decreasing holdings in gilts.

Additionally, the manager can also invest in corporate bonds with high ratings. Investments in corporate bonds will ensure high accrual income. This strategy differentiates dynamic bonds funds from gilt funds. However, the tables can turn too. The fund manager’s opinion about the market can go wrong, and the dynamic debt fund can face significant losses.

Features of dynamic bond funds

No Debt Fund mandate

Unlike other debt funds, dynamic funds do not have an investment mandate to adhere to. For instance, short term bond funds have to invest only in short term securities. On the other hand, dynamic bond funds have no such restriction. They can invest in long term securities just for one month as well. The entire strategy revolves around the interest rate movements.

Macroeconomic factors

Macroeconomic factors such as new government policies, fiscal deficit, and oil prices, etc. may have an impact on the returns. Therefore, it is advisable to invest for long durations to minimize the short term risks.

Risk

Similar to other instruments, dynamic funds also have a certain amount of risk. However, these funds are better in comparison to short term funds. Short term funds do not have the advantage to use the duration strategy. Also, if the portfolio manager is unable to alter the portfolio as necessary, it might have an impact on profits.

Interest rates

The bond prices have an inverse relationship to interest rates. In other words, if the interest rates are increasing the price of the bond decreases and vice versa. Furthermore, if interest rates continue to fall, the bond prices will rally on the basis of the remaining maturity. Additionally, the holdings in medium term and short term corporate bonds will help in generating interest income.

Taxation

Dynamic bond funds are taxed like any other debt funds. The short term capital gains are taxable at an individual’s income tax slab rate. The long term capital gains are taxable at 20% with indexation benefit. Also, Debt funds require an investor to stay invested for at least three years to benefit from capital gains.

Benefits and Limitations of Dynamic Bond Funds

Benefits of dynamic bond funds

Dynamic asset allocation

Dynamic bond funds have the flexibility to invest in securities across investment duration. They don’t have to follow any investment mandates like other debt funds. They can invest in both short duration and long duration securities without any restrictions. Their dynamic asset allocation also helps them in taking advantage of the interest rate movements. In a falling interest rate scenario, they can invest in long duration securities. While in the rising interest rate scenario, they can invest in short duration securities.

Tax efficiency

Ideally, one has to invest in dynamic bond funds for a duration of 3-5 years. By staying invested for three years, one can take advantage of the taxation of these funds. Dynamic bond funds are taxed at 20% with indexation benefit. Investors falling under high tax brackets will benefit from this the most.

Limitations of dynamic bond funds

Fund manager’s role

The fund manager plays a crucial role in the performance of dynamic bond funds. Since the asset allocation of these funds depends on market interest rate movements, any wrong move might affect the fund negatively. A fund manager’s predictions, his/her view about the market are very subjective decisions. If their view about the market is wrong, then the fund’s performance is affected.

Interest rate risk

Dynamic bond funds are subject to interest rate risk. The fund’s portfolio is modified according to the interest rate movements. Any wrong call can affect the fund returns adversely.

Macroeconomic factors

Macroeconomic factors like oil prices, government policies, currency rates, the fiscal deficit can affect the interest rate movements and hence affect the performance of the dynamic bond funds.

Unknown trends of interest rate in the market

During the period where the interest rate trends are not known to the portfolio managers of the fund house due to lack of clarity on the market, the fund’s performance might be affected. During these conditions, the fund might have a higher credit risk. Furthermore, long maturity periods can make them volatile.

Who should invest in dynamic bond funds?

Dynamic bond mutual funds are ideal for an investment horizon of 3-5 years. However, these funds don’t suit all investors. These funds are not for investors who expect fixed returns with low risk. Returns from dynamic bond funds depend on interest rate movements. Hence the risk in them is moderately high.

These funds are meant for investors who want to participate in the bond market but do not want to take any decisions on interest rates. Conservative investors who do not want to bet their investments on fund managers’ decisions can stay away from dynamic bond mutual funds.

Dynamic bond funds are subject to interest rate risk and credit risk. They do not have restrictions on the duration and credit quality of securities they can invest in. Hence their broad portfolio might affect the fund’s performance when the market moves against the fund manager’s expectations.

Therefore, investors who understand the risk in these funds can invest in them for a duration of 3-5 years. However, Scripbox doesn’t recommend these funds to investors.

Things to remember before investing

Following are the things to consider before choosing dynamic bond funds to invest. 

Historical performance

It is essential to study the historical performance of a fund before investing. Therefore, it is good to assess the fund’s performance (annualized returns) for the last five years at least before choosing the dynamic bond funds to invest.

Performance during interest rate movements

Study how efficient was the fund to manage the downside risk during the phase where the interest rates were increasing. Hence, studying the fund’s performance during different market cycles is important.

Modified duration

While investing in debt funds, investors often consider the modified duration. If the modified duration of the fund matches with the investor’s horizon, then they invest in it. It is advisable that the investors’ horizon matches with the modified duration.

Long investment durations

Investors with a minimum investment horizon of three years should invest in dynamic bond funds. Returns in the short term are volatile, and hence dynamic bonds are recommended for long durations.

Additional source of income

Dynamic bonds funds are a good investment option for an additional source of income. Therefore, investors can have these funds in their portfolio to generate some additional income. However, they have moderately high risk and investors who understand this can invest in them.

Conclusion

Dynamic bond funds have the flexibility to invest across investment duration. Hence it can be considered a long and short duration fund. Furthermore, they do not have any restrictions on investing across the credit quality spectrum. Additionally, they are subject to the fund manager’s outlook on the market and interest rates. Hence these funds have high credit risk, interest rate risk and fund manager risk.

“Scripbox does not recommend these funds in this category. We believe that the potential incremental return is not justified by the higher credit risk and higher interest rate risk.”

Published on September 3, 2020