Dynamic bond funds can offer good returns
6 min read
Jitendra Solanki
In recent months, the increase in interest rates has provided investors with opportunities to invest in fixed income options. Not only fixed deposits (FDs), but also debt mutual fund schemes have seen significant interest from risk-averse investors. The primary reasons for this are the rise in yields due to higher interest rates and the tax efficiency of this category of schemes.
Investors can choose debt mutual funds based on their risk-taking capacity and time horizon. However, dynamic bond funds have performed exceptionally well in recent months. These funds have successfully taken advantage of interest rate movements to provide good returns. The question now arises: how do dynamic bond funds work, and when should investors include them in their investment portfolio?
What are Dynamic Bond Funds?
Dynamic bond funds are debt mutual fund schemes that invest in debentures, certificates of deposit, commercial papers, bonds, and government securities. The investment in each of these instruments varies according to the schemes and is entirely dependent on the fund manager's discretion. Unlike regular debt funds, dynamic bond funds are not required to invest in any particular proportion of these instruments.
How Do Dynamic Bond Funds Work?
In a typical debt fund, investments are made in underlying securities in a specific proportion, and the maturity of these securities aligns with the scheme's objectives, with no frequent changes. For instance, if it is a long-term scheme like a gilt or income fund, the portfolio's maturity is also long-term, whereas short-term funds invest in short-term securities. These securities are affected by fluctuations in interest rates, and the fund manager may adjust the affected securities, such as gilts in an income fund. However, changes across the entire portfolio are not made frequently.
In contrast, dynamic bond funds grant fund managers the authority to adjust the investment proportions of various securities in response to interest rate movements, thus changing the portfolio's duration. Therefore, if there is a prospect of rising interest rates in the future, dynamic bond fund managers increase the share of short-term papers in the portfolio, thereby reducing the portfolio's maturity. Short-term bonds are less affected by rising interest rates, allowing the fund manager to take advantage of market volatility and provide better yields in the short term. Currently, these funds primarily invest in NCDs, corporate deposits, and commercial papers, reflecting the relatively short-term maturity of the portfolio.
Conversely, when there is a trend of falling interest rates, the portfolio's duration is increased to benefit from the rising prices of long-term bonds. Hence, when interest rates start to decline, dynamic bond funds typically yield good returns. In such situations, the fund manager adjusts the proportion of investments in gilts and corporate bonds to capitalize on market opportunities and generate good returns.
Fund managers can also invest in cash. If there is significant short-term interest rate activity, the entire portfolio can be shifted to cash. This helps fund managers avoid the risk of making incorrect decisions and invest the fund when opportunities arise.
Performance of Dynamic Bond Funds
In recent times, most dynamic bond funds have performed well. The primary reason for this strong performance has been active management and adjusting the maturity profile according to the opportunities presented by the interest rate environment. For instance, the SBI Dynamic Bond Fund increased its average maturity profile to over eight years in November 2011, but reduced it to less than one year by March 2012. Similarly, the average maturity of the Reliance Bond Fund was 11.5 years in November 2011, which was reduced to 3.73 years by March 2012. This strategy benefited these funds, making them top performers in the last quarter. Most other dynamic bond funds also followed a similar approach, increasing the average maturity to 11.5 years in November 2011 and reducing it to 3.73 years by March 2012.
When examining the long-term performance of these funds, only a few have consistently performed well. Birla Sun Life Dynamic and IDFC Dynamic Bond Fund are two such funds that have provided consistently better returns in both short-term and long-term market conditions. The SBI Dynamic and Reliance Dynamic Bond Funds performed exceptionally well in the last quarter of this year because their fund managers made the right decisions. However, in terms of long-term performance, these two funds have lagged behind. By actively managing the portfolio's average maturity, dynamic bond funds can generate good returns in both rising and falling interest rate scenarios.
Performance of Dynamic Bond Funds (as of May 2012, in percentage returns):
Birla Sun Life Dynamic Bond Fund (Growth)
3 Months: 2.19%
1 Year: 10.27%
3 Years: 7.54%
5 Years: 9.46%
Average Maturity: 1.8 years.
Canara Robeco Dynamic Bond Fund
3 Months: 1.98%
1 Year: 8.90%
Average Maturity: 0.02 years.
IDFC Dynamic Bond Fund (A Growth)
3 Months: 1.73%
1 Year: 11.61%
3 Years: 5.65%
5 Years: 9.30%
Average Maturity: 1.80 years.
Reliance Dynamic Bond Fund (Growth)
3 Months: 1.37%
1 Year: 10.84%
3 Years: 6.42%
5 Years: 4.45%
Average Maturity: 3.73 years.
SBI Dynamic Bond Fund (Growth)
3 Months: 1.89%
1 Year: 12.42%
3 Years: 8.00%
5 Years: 4.50%
Average Maturity: 0.95 years
Tata Dynamic Bond Fund
3 Months: 1.55%
1 Year: 6.99%
3 Years: 4.30%
5 Years: 5.48%
Average Maturity: Not specified.
Taurus Dynamic Bond Fund (Growth)
3 Months: 2.52%
1 Year: 10.53%
Average Maturity: 1.76 years
UTI Dynamic Bond Fund (Growth)
3 Months: 1.82%
1 Year: 9.68%
Average Maturity: 4.15 years
(Note: Returns for periods longer than one year are annualized.)
Who Should Invest in Dynamic Bond Funds?
For small investors, selecting funds that make interest rate-based decisions and are actively managed can be challenging. Most financial planners also find it difficult to fully understand the complex debt market. Therefore, it is advisable to leave investment decisions based on interest rates to fund managers. Dynamic bond funds can be a good choice to take advantage of fluctuating interest rate conditions.
From a long-term investment perspective, Birla Dynamic Bond Fund, with its large asset size under management, low expenses, and good returns with low volatility, can be a suitable choice. Additionally, the IDFC Dynamic Bond Fund can also be selected as it has been successful in managing its portfolio effectively.
Investors who do not wish to make decisions based on interest rates themselves can include dynamic bond funds in their portfolios. Funds with a lower average maturity could provide good returns over the next three to six months if interest rates decrease. Investors willing to take a bit more risk for long-term investments can opt for regular debt funds such as gilt or income funds, which can offer good returns over the next two to three years if interest rates decline. However, those who prefer not to take on much risk but still want to benefit from interest rate conditions can choose Birla Dynamic and IDFC Dynamic Funds for long-term investments as well.
Investors should be aware that the biggest risk in dynamic bond funds is the fund manager's performance. Therefore, the track record of the fund manager is crucial when selecting dynamic bond funds.
The author is a Certified Financial Planner at J. S. Financial Advisors based in Delhi.
