Invest in dynamic bond funds to manage the impact of the interest rate cycle

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The Reserve Bank of India (RBI) has raised its key rates twice since May and expectations of further rate hikes are not ruled out. Against this backdrop, fund managers advise investors to consider investments in dynamic bond funds – mutual fund (MF) schemes that gain exposure to debt securities with extended maturities.

The fund managers of these plans modify allocations based on their interest rate outlook.

“After a sell-off of more than 100 basis points (bps) in the bond market over the past year, the return potential of debt funds has improved significantly. We suggest investors increase the allocation to dynamic bond funds in a staggered manner with a holding period of two to three years,” says Pankaj Pathak, bond fund manager, Quantum MF.

In May, the RBI raised rates by 40 basis points and another 50 basis points in its June monetary policy. When the central bank started raising rates, 10-year government bond yields also tightened.

Fund managers are not looking to increase maturities due to expectations of further rate hikes. Currently, they see value in bonds maturing between three and five years.

If yields continue to rise, as expected by fund managers, funds with medium to short durations will be less volatile than those with longer durations.

“We have used the recent rise in bond yields to deploy the portfolio’s cash in three- to five-year government bonds. For the core portfolio, we continue to like bonds with three to five year maturities, which we believe provide a critical balance between duration and accrued yield,” adds Pathak.

Generally, the prices of fixed income securities are dictated by prevailing interest rates. Interest rates and prices are inversely proportional. When interest rates fall, the prices of fixed income securities rise. Similarly, when interest rates rise, the prices of fixed income securities fall.

Over the past year, these funds have, on average, delivered returns of 2.02%, while over the three-year period, they have managed to deliver returns of 5.6%. Some funds in the category have given returns in the 3-6% range over the past year.

Dynamic bond funds are generally more volatile than short and medium term debt funds. However, they also have the potential to yield superior returns under different interest rate scenarios over longer investment terms.

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