Are Dynamic Bond Funds a Good Bet?

With bond yields rising sharply, many believe that the market has largely influenced future repo rate hikes. There is a range of possible adverse effects on debt funds i.e. fall in fund NAV as bond prices fall along with increase in repo rate along with increase in yields. Investing in debt funds, which can invest in relatively longer maturity papers that may offer higher returns or better still, invest in funds that offer a mix of debt papers with shorter and longer maturity as needed can be modified from the form, thus today is seen as a good option.

Vidya Bala, Co-Founder, PrimeInvestor.in says, “In our view, if it is clear that rates are peaking, gilt or continuous maturity makes an easier option.

return and risk

Mahendra Jaju, CIO – Fixed Income, Mirae Asset Investment Managers (India) says, “While their flexibility is an important selling point, how much DBFs really leverage it depends on the fund’s interest rate outlook and to what extent Timely deploys its portfolio for profits – minimizes mark-to-market losses when rates rise and aims to provide superior returns when rates fall – once expected After the rate action is implemented.”

For our analysis, we have looked at how the DBF has performed during the previous phases of rate cuts and a major phase of rate hikes, later when the repo rate increased from 5% in March 2010 to 8.5 per cent by October 2011 . All DBFs with a history of at least seven years have been considered for the purpose of this analysis (except for those with diversified portfolios). We look at the fund’s performance during the actual phase of rate hikes/cuts, assuming that fund managers will begin revising their portfolios to suit their changing rate view even before actual rate action begins. The data suggests that DBFs can have broader returns, especially in periods of sharp rate cuts (or hikes), such as the aftermath of the global financial crisis. In other words, choosing the right DBF becomes very important.

On average, the returns of DBFs may not be much higher than those of relatively restricted category such as short duration funds (see table).

“Dynamic bond funds help eliminate the need to change your strategy as the interest rate cycle changes. However, this means that the fund manager should take the right active calls on time. However, within this category, the practices are so diverse in terms of increasing or decreasing maturity that there is a high probability that you are in a fund that does not do this well,” says Bala. She adds, “ Currently, around 14 funds in this category out of 25 have not increased their maturities marginally since March 2022, a sign that they are ready for a rate fall-driven rally. But 11 funds have actually reduced their maturity or kept it stagnant.”

In addition to the interest rate risk call being inaccurate, it is also worth looking at the credit quality of the fund portfolio. Today, most DBFs hold only ultra-secured government securities (g-secs), and AAA and A1+ rated (highest ratings for long and short term papers, respectively) debt instruments, making them very safe on the credit risk front. Huh. However, some funds have exposure to AA+ and AA-rated papers, which are just a notch below AAA-rated papers. In the past, Franklin Templeton MF, UTI MF and ABSL MF have had to create separate portfolios in their respective Dynamic Bond Funds due to credit downgrade/default.

investor implications

Although DBFs may have low credit risk, they are not for everyone as they carry interest rate risk. According to Jaju, they are for people with a high return profile with relatively high risk. He further points out that since bond yields have already risen sharply, today, target maturity funds that help investors increase existing portfolio yields with a lower range, can be a less risky option.

Vishal Dhawan, Founder and CEO, Plan Ahead Wealth Advisors, lists down a few points that one must keep in mind before investing in a DBF. “One, you are putting yourself at risk that the fund manager’s interest call goes wrong. Second, you should be aware that if this approach is being implemented using G-Secs, it can be done more easily as it is the most liquid part of the market. But the ability to move to other segments can be a bit daunting.” He adds, “Apart from the possibility of the fund manager being wrong, you may also be hit by a high expense ratio”. ACE MF data shows that Most DBFs charge expense ratios of 0.3% to 1.0% (direct plan) and 0.7% to 1.7% (regular plan). In comparison, most short duration debt funds charge 0.2% to 0.4% and 0.7% to 1.3%, respectively. Many target maturity ETFs and index funds (direct plans for the latter) charge 0.15% to 0.30% or even less.

Dhawan feels that such funds can be invested but it should not exceed 20 per cent of the total debt allocation. This is for investors who are a firm believer in taking an interest rate based approach. For most other investors, he suggests a maximum allocation of 5-10%.

first article