Manage debt market volatility by investing in dynamic bond funds

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Although debt as an asset class is relatively less volatile than equities, we have seen a fair amount of volatility in debt markets lately. Inflation concerns have led to a change in monetary policy stance by central banks around the world, including India.

We are in the midst of a cycle of rising rates and the ever-changing global growth and inflation dynamics have kept debt markets on their toes. While this volatility is here to stay for a while, it is important for investors to understand that staying on the sidelines and waiting for volatility to subside can impact their overall portfolio returns and they may miss out on investing. higher yields.

Investors are generally confused about whether to choose long or short duration funds and when to switch between them. Given changing market dynamics and timing challenges, dynamic bond funds should be considered.

Dynamic bond funds are open-ended debt funds that have the flexibility to invest in securities of different maturities, including money market instruments, medium/long-term bonds and G-secs. These funds invest primarily in high credit quality instruments as the focus is on generating returns through capital gains by capturing market movements rather than through accrual income.

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These funds have no restrictions on average maturity or duration, and the fund manager can change the fund’s maturity based on their interpretation of market dynamics and the interest rate cycle. This means that if the fund manager expects interest rates to rise, he will reduce the average maturity of the portfolio and if interest rates are expected to fall, the average maturity of the portfolio will be increased. This is because the change in interest rates is inversely proportional to the price of bonds and bonds with longer maturities have a greater impact on prices due to the change in interest rates compared to bonds with shorter maturities. . Thus, with this dynamic management, the objective is to reduce losses in periods of rising interest rates by managing a lower average maturity and to generate capital gains in periods of falling interest rates by maintaining a higher average maturity.

Additionally, as we are in the midst of a rate hike cycle with the potential for a further rise, investors can consider staggering their investments over the next six to 12 months through systematic investment plans. (SIP).

Investing through SIP can help manage volatility effectively, as regular investments over a period of time help spread risk evenly. During a period of rising interest rates, laddered investments help smooth volatility by accumulating higher units. These higher units then help earn higher returns when the interest rate cycle reverses.

Let’s understand this better with an example. Consider a monthly SIP of 10,000 in the Crisil Dynamic Bond Fund AIII index from January 2010 to March 2012, which was a rate hike cycle. Those who invested laddered over this period and stayed invested in the fund for more than three years, say until January 2015, would have earned an extended internal rate of return of 9.2%. The value of their investments would have reached 3.8 lakh against a cumulative investment of 2.7 million.

While laddered investments help spread risk and dynamic duration management helps reduce the impact of changing long-term interest rates, it is important to understand that this can also lead to higher volatility. high in the short term. It is therefore advisable to invest in dynamic bond funds with an investment horizon of at least three years and more.

This allows aggressive bond funds to offer tax-efficient returns over traditional investment avenues since mutual funds offer the benefit of indexing.

The long-term capital gains tax on investments held for more than 3 years is 20% after indexation (adjusting the investment for inflation) to the marginal tax rates in case of traditional investments.

So, if you understand the risk and can remain patient during periods of volatility, systematic investments in debt funds can help you build a reasonable body of stock over a period of time. The important aspect for any investment to produce returns is to stay invested and follow the current cycle until you reach your financial goal.

DP Singh is Deputy Managing Director and Commercial Director at SBI Mutual Fund

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