Want to benefit from downturn in interest rates? Go for a dynamic bond fund

Investors who don't want to take interest-rate risk may avoid these funds

After the Reserve Bank of India (RBI) paused its rate hike cycle in April, many investors are trying to figure out whether it could hike the repo rate again, begin to cut it soon, or keep it at a high level for a long time. While they want to benefit from a downturn in interest rates, they are not sure whether this is the right time to enter longer-duration funds. Such investors should consider investing in a dynamic bond fund, a category that currently has 25 funds with total assets under management of Rs 31,835 crore.

How do they work?

The Securities and Exchange Board of India (Sebi) allows most debt fund categories to hold bonds within a narrow maturity range. “Fund managers of dynamic bond funds enjoy complete flexibility. They can change the duration of their fund to any extent, as and when they like,” says Arnav Pandya, founder, Moneyeduschool.  

These fund managers try to generate higher returns by playing the interest-rate cycle. Before rates fall, they try to anticipate the event and increase the modified duration of their funds, so that their funds enjoy a return kicker when rates fall. Similarly, when interest rates are set to rise, they try to foresee it and reduce duration, so that the mark-to-market impact is minimised.

Benefit from professional management

To monitor and evaluate where one is currently in the rate cycle and taking the right duration call is difficult. “Many investors may not have the time to track the debt markets, or they may lack the understanding to perform the task of adjusting duration according to the interest-rate outlook,” says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund.

To change the duration of funds in their portfolios, investors will have to sell one debt fund and move to another. “This gives rise to tax implications, which can be avoided by investing through a dynamic bond fund,” says Pathak.

Timing the rate cycle is difficult

Experts say that to time the interest-rate cycle precisely, and on a consistent basis, is very difficult. “A lot of fund managers have got these calls wrong in the past. Even if somebody has got them right in the past two cycles, one can still not be too sure they will get it right in the future. Hence, finding the right fund manager who can do the job consistently is not easy,” says Arun Kumar, head of research, at Fundsindia.com.

When the calls go wrong, the returns from these funds can be lower than what the investors would have earned from a plain-vanilla shorter-duration fund.  

The expense ratio of the category tends to be high. “This puts an additional burden on the fund manager to generate extra return so that he is able to offset the higher expense ratio and yet produce returns for investors,” says Kumar.

Are these funds for you?

These funds are for investors who wish to earn some extra returns by timing the interest-rate cycle. Suppose that an investor has a debt fund portfolio of Rs 100. Of this, he may put Rs 70 in safe, shorter-duration funds with high credit quality. In the balance part of his portfolio, he may want to take some duration risk, which he can do via dynamic bond funds (for credit risk he may opt for credit risk funds).

Investors with a clear idea of their investment horizon, who wish to avoid any risk, should stay clear of these funds. “They can instead opt for a target maturity fund that matures around the same time they need the money,” says Pandya.

How to select the right fund?

Investors should not go with the fund manager who has produced the highest return in the past. “Check the performance of fund managers across several interest-rate cycles and go with the one that has a consistent track record,” says Pathak. He adds that one should also avoid dynamic bond funds that take credit risk.

Adds Kumar, “Make sure the expense ratio is not high compared to a plain-vanilla shorter-duration fund.”

 

Best performers over long term

Fund	Return (%)
	1-year	3-year	5-year	10-year
ICICI Pru All Seasons Bond Fund	7.14	6.64	7.66	9.26
Kotak Dynamic Bond Fund	5.02	5.74	7.42	8.05
AXIS Dynamic Bond Fund	6.1	5.78	7.54	7.56
DSP Strategic Bond Fund	5.86	4.61	7.32	7.46
UTI-Dynamic Bond Fund	13.11	9.66	5.72	7.37
Bandhan Dynamic Bond Fund	4.98	4.36	7.31	7.34
SBI Dynamic Bond Fund	7.58	4.98	7.48	7.33
*Returns are of regular, growth funds
Source: NGEN Markets