Are dynamic bond funds a good bet?

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Dynamic Bond Funds (DBFs) seem to be the flavor of the season. They have the flexibility to change the average duration or maturity of their overall debt portfolio to take advantage of changes in interest rate cycles. Most other debt funds have a defined band within which they must manage their duration.

With bond yields soaring, many believe the market has largely priced in future repo rate hikes. There is a limit to the potential negative impact on debt funds, i.e. the fall in the net asset value of the fund when bond prices fall with rising yields, as the repo rate is increased. Invest in debt funds that can gain exposure to relatively longer dated debt securities offering higher yields or, even better, in funds that can freely change their mix of shorter and longer dated debt securities long as needed, is therefore considered a good choice today.

“In our opinion, if it’s obvious that rates have peaked, then gilts or constant maturity are easier options,” says Primeinvestor.in co-founder Vidya Bala.

Returns and risks

Mahendra Jajoo, CIO – Fixed Income, Mirae Asset Investment Managers (India), says: “While their flexibility is a key selling point, how DBFs actually benefit depends on the fund’s view on rates. interest rates and the extent to which the fund positions its portfolio in time to benefit from them – minimizing mark-to-market losses when rates rise and aiming to provide better returns when rates fall – once the expected rate action is materializing.”

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For our analysis, we looked at how DBFs performed during the last phases of falling rates and a significant phase of rising rates, the latter when the repo rate rose from 5% in March 2010 to 8, 5% in October 2011. All DBFs with at least seven years of history were taken into account for this analysis (excluding funds with separate portfolios). We look at fund performance during the real phase of rate hikes/cuts, assuming that fund managers would start altering their portfolios based on their changing view of rates, even before the real rate action is initiated. The data shows that DBFs can have extended returns, especially in times of sharp declines (or rises) in rates, such as after the global financial crisis. In other words, choosing the right DBF becomes very important.

On average, the performance of DBFs may not be significantly higher than that of a relatively small category such as short-term funds (see table).

“Dynamic bond funds save you from having to change your strategy as the interest rate cycle changes. However, this means that the fund manager must take the right active calls over time. However, within this category, the practices are so varied in terms of increasing or decreasing maturity that there is a good chance that you are in a fund that does not time it well,” says Bala. She adds: “Currently, of the 25 funds in this category, around 14 have slightly or even significantly increased their maturity since March 2022, signaling that they are ready for a recovery led by lower rates. But 11 funds actually reduced their maturity or kept it stable.”

Along with interest rate risk calls that go wrong, one should also look at the credit quality of the fund portfolio. Today, the majority of DBFs only hold ultra-safe government securities (g-secs) and debt securities rated AAA and A1+ (highest rating for long-term and short-term paper, respectively) , which makes them very safe on the credit risk front. A few funds, however, have exposure to AA+ and AA rated papers, which are just a notch below AAA rated papers. In the past, Franklin Templeton MF, UTI MF and ABSL MF had to create separate portfolios in their respective dynamic bond funds due to credit downgrades/defaults.

Implications for investors

Even though DBFs may have low credit risk, they are not suitable for everyone as they carry interest rate risk. According to Jajoo, they are for those with a relatively high performance profile. He further points out that since bond yields have already risen sharply, today target-maturity funds that help investors increase current portfolio yields with low variability may be a lower-risk option.

Vishal Dhawan, Founder and CEO of Plan Ahead Wealth Advisors, lists a few things to consider before investing in a DBF. “First, you expose yourself to the risk that the fund manager is wrong about its calls for interest. Second, you should be aware that if this view is implemented through the use of g-secs, it can be done more easily as it is the most liquid part of the market. But the ability to move into other segments can be a bit more difficult.” He adds: “In addition to the possibility that the fund manager’s vision is wrong, you could also be affected by the higher expense ratio. ACE MF data shows that most DBFs charge expense ratios of 0.3% to 1.0% (direct plans) and 0.7% to 1.7% (regular plans). Compared to this, most short-term debt funds charge 0.2% to 0.4% and 0.7% to 1.3% respectively Many ETFs and target-maturity index funds (direct plans for the latter ) charge 0.15% to 0.30% or even less.

Dhawan believes that one can have exposure to such funds, but this should be limited to no more than 20% of total debt allocation. This is for investors who strongly believe in taking an interest rate based approach. For most other investors, he suggests an allocation of no more than 5-10%.

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