What Are Dynamic Bond Funds?

With falling deposit rates, risk averse investors are turning to debt oriented mutual funds to achieve returns that keep up with inflation. Dynamic Bond funds, a category of debt mutual funds, have received significant attention off-late. However, many investors remain uninformed about how Dynamic Bond Funds actually work, and what the key risks of investing into them are.

How Debt Funds Make Returns
While most investors understand that debt funds invest into bonds, and therefore ‘accrue’ whatever interest these underlying bonds pay out, very few understand the concept of ‘total returns’ from debt funds. After all – have you ever wondered how a debt fund which comprises of bonds that have (on average) a coupon rate of 8%, sometimes end up giving you returns of 10-12% per annum? That’s what total returns are all about.

Put simply, ‘total returns’ comprise of the coupons paid out by the underlying bonds, plus the capital gains arising from the increase in bond prices. Bond Prices are inversely proportional to interest rates, implying that they have the highest capital gains potential when rate cycles are at their peaks or near peaks. Additionally, longer duration bonds are far more price-sensitive to changes in rates (and subsequently, yields).

So, What Makes Dynamic Bond Funds ‘Dynamic’?
Most debt funds fix the average maturity of the bonds within their portfolios to a prespecified range. For instance, SBI Short Term Debt Fund holds a portfolio of bonds that have a weighted average maturity of 2 years, and will likely keep this number in the range of 1-2 years always. On the other hand, ICICI Prudential Long Term GILT Fund (a debt fund that invests purely into long term government securities), currently has an average maturity of 23.2 years, and it will hold this number in the >20-year range at most times.

What this means is that in falling interest rate scenarios, longer duration debt funds outperform shorter duration ones, and vice versa – as their portfolios are a lot more rate-sensitive.

Dynamic Bond Funds on the other hand, unlike it’s static-duration counterparts, can switch from lower duration to lower duration bonds at short notice, and vice versa. For instance, if the fund management team believes that an interest rate cycle has peaked out, it could increase its portfolio duration and start functioning like a long-term debt fund. If the fund manager believes that rates have bottomed out – thereby increasing the risks of capital losses on longer term bonds, it can cut its portfolio weighted average maturity sharply. In this manner, it can potentially ‘ride the rate cut waves’ more effectively by timing the bond markets, in a manner of speaking.

Risks Of Dynamic Bond Funds
As is the case with all investments, there are no free lunches! With Dynamic Bond Funds, you expose yourself to the risk of the Fund Manager’s call going wrong. For instance, your Fund Manager may be preparing his portfolio for a series of rate cuts, only for global risks to upset the apple cart for force the RBI to adopt a hawkish stance instead. In such a scenario, you could end up incurring losses. Similarly, your Fund Manager may decide to adopt a cautious approach, reduce portfolio duration, and focus on accruals – only to have yields fall. In such a scenario, you’d miss the rate cut rally.

A Word Of Advice For Investors
If you’re planning to invest into a dynamic bond fund, stick to AMC’s with pedigree, a track record, and proven research capabilities. The Fund Manager’s ability to time the rate cycles and the direction of bond markets will play a critical role in determining the performance of your Dynamic Bond Fund – make sure your fund is managed by a seasoned manager and not a freshly minted IIM graduate! Avoid NFO’s (New Fund Offers) in this space and opt for a fund that has a 5 year track record across rate cycles.