Dynamic bond funds: Check rate-cycle track record before investing

The ongoing India-Pakistan conflict and the fear of it escalating has created uncertainty among investors. While the equity markets have held steady so far, they could take a hit if fear and uncertainty ratchet up further. Investors need an allocation to fixed income to lend stability to their portfolios in this environment.

 

Moreover, the interest rate environment is uncertain, making it difficult for many fixed income investors to select the right debt fund. While two repo rate cuts have taken place, there is limited room for further reductions by the Reserve Bank of India (RBI). In such an environment, a dynamic bond fund (DBF) can help investors navigate rate cycles effectively.

 

“DBFs offer the advantage of active duration management, allowing fund managers to tactically shift between short- and long-term debt instruments based on evolving interest rate scenarios. They are particularly suited for uncertain or transitional interest rate environments and can deliver superior risk-adjusted returns compared to static or passive duration debt funds,” says Devang Shah, head – fixed income, Axis Mutual Fund.

 

Their category average return over the past year has been attractive at 10.4 per cent. 

 

Fund manager flexibility

 

Unlike other debt fund categories, DBF managers are not bound by fixed duration or credit quality mandates. “DBF provides complete flexibility to invest across the entire spectrum of duration and credit. When interest rates are high and are expected to come down, DBFs can run a higher duration like an income or gilt fund. When interest rates are low, DBF can run a lower duration like a low-duration fund,” says Kaustubh Gupta, co-head fixed income, Aditya Birla Sun Life Asset Management Company (AMC).

 

Managers may also opt for durations that maximise yield in a range-bound interest rate scenario. 

 

Fund manager risk

 

DBFs’ in-built flexibility also introduces fund manager risk. An incorrect view on rates can dampen returns. “Their performance is highly dependent on the fund manager’s ability to make timely and accurate interest rate calls. This introduces an element of unpredictability and potential volatility in returns,” says Shah.

 

Returns over the past year ranged from 8.09 per cent to 12.03 per cent, underscoring the importance of fund manager skill.

 

“These funds can be more rate sensitive than moderate duration funds as unfavourable duration or yield curve positioning can lead to higher mark-to-market volatility,” says Anurag Mittal, head of fixed income, UTI AMC.

 

Buy and hold

 

Long-term investors in these funds can benefit from compounding. “DBF is an all-season fund where we can change the duration and other attributes according to the changing macro and market conditions. It is a good investment choice at this moment,” says Gupta.

 

Investors willing to hold through rate cycles, i.e. three to five years, should benefit. “A conservative fixed income investor whose objective is downside risk mitigation can invest 20–30 per cent of their portfolio in DBFs, while a more aggressive investor can consider 30–40 per cent allocation,” says Mittal.

 

Check track record

 

Select a scheme with a proven track record. “Assess the fund’s risk profile and positioning as the success of a DBF is highly dependent on actively managing duration and asset allocation. Also, evaluate the track record of the fund in navigating shifting market conditions effectively,” says Mittal.

 

Review the potential risk class matrix and risk-o-meter. The former shows the maximum risk a manager can take, while the latter reflects the scheme’s current risk level. A lower expense ratio can also enhance net return.