Should you invest in dynamic bond funds to navigate the interest rate cycle?

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As their name suggests, dynamic bond funds have leeway to manage their duration or maturity depending on the direction that fund managers predict for interest rates.

With interest rates currently heading north, the Dynamic Bond Fund category currently maintains an effective maturity of 3.49 years. Fund managers who expect interest rates to rise will generally have a shorter duration. Funds like IDFC Dynamic Bond Fund (99%) and Mirae Asset Dynamic Bond (75%) hold a larger portion of their portfolio in securities with a duration of 3 to 5 years.

In comparison, long-duration funds hold an effective maturity of nearly 12 years. By definition, the Securities and Exchange Board of India (SEBI) requires long duration funds to maintain a Macaulay duration of more than seven years.

Medium to long duration funds maintain an effective maturity of almost 7 years. Similarly, medium to long duration funds keep the Macaulay duration between four and seven years.

In contrast, dynamic bond funds have no restrictions on the duration or maturity of the securities in which they invest.

Where are they investing?

These funds invest in a combination of government securities (central and state), corporate bonds and retain a cash portion. As of April 2022, two funds held over 90% of their net assets in government securities – IDFC Dynamic Bond (99%) and Nippon India Dynamic Bond (95%).

Funds like ITI Dynamic Bond, DSP Strategic Bond, L&T Flexi Bond and Quantum Dynamic Bond hold more than 70% of their net assets in money market instruments, with terms of less than one year.

Performance over different rate cycles

We looked at the performance of Dynamic Bond Funds from October 2008 to May 2022 during rate hikes, declines and flat periods.

Dynamic Bond Funds generated double-digit returns during a declining interest rate regime. From October 2011 to July 2013, when the policy repo rate fell from 8.50% to 7.25%, the dynamic fund category generated an annualized return of 10.96%, outperforming other categories such as liquid, ultra-short duration, floating rate, credit risk and short to medium term funds. Duration fund.

However, during the rate hike cycle (July 2013 to January 2014), these funds delivered -0.03%. Similarly, from October 2017 to August 2018, when the policy rate fell from 6% to 6.5%, the Dynamic Bond fund category recorded a meager 0.60%, underperforming other categories such as liquid, ultra-short duration, short duration and floating rate funds.

In recent times, from May 2020 to May 2022, when the repo rate remained stable to revive the economy, the dynamic fund category generated 3.74% while floating rate funds generated 5.54%. Credit risk was the best performing category (7.58%) during this period, followed by medium duration funds (6.15%).

As the table above shows, returns in this category can be very volatile depending on the direction of interest rates and the duration of the fund.

It is advisable to invest at least three years in this category because interest rates follow a cycle. Funds with a longer duration, which expect rates to fall, may be sensitive/volatile to changes in interest rates over a shorter duration.

How much of your debt allowance should be invested in these funds? “Because these funds can accept large interest rate calls, the invested corpus is exposed to the skills of the fund manager in assessing macro conditions and selecting stocks. So there is this element of risk that has to be considered. As a precautionary measure, investors are advised to allocate the secondary part of their portfolio of fixed income securities to these funds. Let the core allocation remain in regularization fixed income funds with a high credit quality portfolio such as bank and PSU debt funds, corporate bond funds and short term funds,” says Mohasin Athanikar, Investment Analyst, Morningstar Investment Adviser India.

Rushabh Desai, founder of Rupee With Rushabh Investment Service, points out that dynamic bond funds can be quite volatile in the current environment. “I currently do not recommend dynamic bond funds. These funds are similar to 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 or net asset value. In the current scenario of volatility and rising yields, I think it’s best to stick with simple regularization/roll down/target maturity funds somewhere at the shorter end of the yield curve. returns to minimize drastic mark-to-market declines.

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