Bond funds: Should we bet on dynamic bond funds in a scenario of rising interest rates?

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Interest rate hikes are hitting many mutual fund investors hard. RBI raised the repo rate by half a percent this week. Money market experts believe that rates should rise further. In this scenario, many mutual fund managers recommend dynamic bond funds. However, many investors are wary of the track record of these schemes. Are these plans a good investment option for mutual fund investors at this stage?

SEBI defines dynamic bond funds as debt mutual funds that invest in debt and money market instruments such as government securities, corporate bonds, etc. of different durations. These funds have no restrictions on the duration or maturity of the securities they invest. This flexibility allows them to easily navigate different rate cycles. That is why fund managers believe that these funds can be a good option in the current scenario.

However, the performance of the dynamic bond category says otherwise. The funds have not fared well over the past few years, even after the RBI decided to start raising rates this year. “Most aggressive bond funds have a high portfolio duration; are therefore very sensitive to changes in interest rates. These funds perform well when interest rates fall and perform poorly in a rising interest rate environment. However, within the category of dynamic bond funds, there is a wide divergence between the performance of different regimes. Fund selection will therefore play a key role in the dynamic bond fund,” says Pankaj Pathak, Fund Manager, Quantum Mutual Fund.



If you look closely at the dynamic bond fund category, you will see a very different picture. Even though the category gives tiny returns, programs like UTI Dynamic Bond Fund excel. UTI Dynamic Bond Fund offered returns of 19.00% in one year, returns of 7.43% in 6 months and returns of 8.11% in 3 months. The Franklin India Dynamic Accrual Fund offered year-over-year returns of 6.65% and the Dynamic Debt Fund offered year-over-year returns of 6.29%.

The rest of the category has a lot of stragglers. Most funds offer low single digit or negative returns. Fund managers believe this is due to the significant rise in bond yields, not taking into account future rate hikes. “There is an opportunity in medium to long duration bonds. Aggressive bond funds generally perform better in this type of rate environment,” says Pankaj Pathak.

However, investors should remember one crucial thing: risk. Aggressive bond funds could be well placed in this scenario, but they carry risks and could experience extreme volatility. This is the reason why mutual fund advisors are not convinced by these devices.

“I currently do not recommend dynamic bond funds. These funds are like flexi cap funds. However, flexing and maneuvering in different debt instruments on the yield curve can be much more difficult and complicated. Liquidity can be a big issue and is extremely important in the debt market. The lack of liquidity in the corporate bond market may limit the flexibility of these funds. Therefore, they may not be able to maneuver effectively on the yield curve. This can have a huge impact on the fund and its net asset value. In the current scenario of volatility and rising yields, it’s best to stick with simple regularization/roll down/target maturity funds somewhere at the shorter end of the yield curve to minimize the drastic market declines, as the cycle of rising interest rates has not yet been reached. and we are still in the middle,” suggests Rushabh Desai, founder of Rupee with Rushabh Investment Services, a Mumbai-based investment firm.

If you are risk averse and want to get extra returns by betting on risky debt funds, you can opt for dynamic bond funds. Dynamic bond funds are intended for investors with an investment horizon of at least three years. In the intermittent period, there could be high volatility in these funds. Thus, investors should be prepared for higher volatility.

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