Dynamic Bond Funds: Definition, Suitability, Expected Returns

Updated on: Jan 11th, 2022


7 min read

Dynamic bond funds are a class of debt mutual funds that alter allocations between short-term and long-term bonds. This strategy helps in taking advantage of fluctuating interest rates. 

Dynamic Bond Funds

The dynamic bond schemes, as the name suggests, are dynamic in terms of the composition and maturity profile. The main objective of dynamic bond funds is to provide ‘optimal’ returns in both rising and falling market scenarios. It majorly depends on the fund manager’s decisions and management of the portfolio.

These funds generally have huge assets under management (aum), running to a portfolio worth several thousand crores. Sometimes, there could be a long pause in between interest rate changes. This can take a hit on the income of bond investors. Therefore, these funds are an excellent alternative for those wishing to ride the interest rate cycles.

Here, fund managers ‘dynamically’ trade instruments of different maturity periods as per the anticipated change in rates. For instance, during a falling interest rate scenario, a fund manager increases the holdings in long-term instruments like gilts.  

Who can invest in Dynamic Bond Funds?

The dynamic bond funds are ideal for investors who are not experts in making the right calls based on the interest rate movement. Investors with moderate risk appetite and investment horizon of 3-5 years should invest in these funds. A SIP (Systematic Investment Plan) approach will work as it allows you to combat the volatility. However, one should always remember that the returns in dynamic bond funds depend mostly on the interest rate movement.  

Features & Benefits of Dynamic Bonds

Role of Asset Manager

Fund manager’s view of interest rate is exceptionally crucial. As seen with many funds in early 2017, if RBI takes a step contrary to the expectation of the fund manager, profits could be significantly reduced.

Macroeconomic Factors

Factors like oil prices, fiscal deficit, and new government policies could all affect the returns from the dynamic bond funds. One should always stay invested for more extended periods to minimise the short-term risks.

Risk Factors

Like every other instrument, the dynamic bond funds are also exposed to certain risks. These funds are better than the short-term funds because they are unable to use the duration strategy. However, if the fund manager is unable to reduce the portfolio as required, the previous profits earned could be affected.


Bond fund investors should stay invested for at least three years to receive indexation perks on capital gains. Here, dynamic bonds differ from other debt funds. This is because of a potential shift in the interest cycle that can result in higher tax incidence.


The price of bonds is inversely proportional to the changing interest rate. So, if the interest rate is increasing, then the cost of the bond will decrease and vice versa. As the interest rates continue to fall, the price of the bonds will rally to the extent based on the remaining maturity. The fund manager may also hold some short-term and medium-term corporate bonds that additionally generate interest income.

Free from usual Debt Fund Mandate

Generally, all debt funds should adhere to its investment mandate. Example, a short-term bond fund can only invest in short-term securities and vice versa. However, dynamic bond funds need not follow this rule. They can invest in long-term securities for one month even. It all depends on the interest rate movement.

Dynamic bonds

How a Dynamic Bond fund works

Dynamic bonds can switch from long-term to mid-term to short-term securities quickly. For instance, if the fund house deems that an interest rate cycle is about to fall, it can increase its portfolio tenure. Similarly, if the asset manager thinks that rates have hit bottom, resulting in more significant risks of capital losses on long-term bonds, it can reduce the portfolio’s average maturity in short notice. This way, it can iron out the ‘rate-waves’ more efficiently.

Fund managers continuously trade the bonds of varying maturity based on their expectation of change in the interest rate. For instance, the manager will buy more short and medium-term instruments while reducing the holdings in gilts. He may also increase holdings of high-rated corporate bonds to ensure higher accrual income. This is one of the most significant differences between a gilt fund and the dynamic bond funds. The gilt fund manager can only change the maturity of the funds while remaining invested only in the gilts.  

Things to keep in mind when Investing in Dynamic Bond Funds

  • Check if the funds have proven the ability to perform across multiple market scenarios. Assess the performance of the fund over at least five years.
  • See how the fund managed to limit the downside when interest rates shot up over the last few years.
  • Investors must go for a mix of income accrual funds for steady returns and dynamic bond funds as an additional income source.
  • Do not go for dynamic bonds if your investment horizon falls short of three years.
  • It is advisable to stay away from New Fund Offers (NFO) in dynamic bonds and choose the one with at least 5-year track record.

In short, dynamic bond funds are slightly riskier by debt fund standards. However, they can also deliver higher returns compared to the rest of them. If you find it tedious and difficult to research and choose the most suitable debt fund, you can invest with ClearTax Save.

We have done the research and handpicked funds from the top fund houses in the country. Start investing – the entire investment process can be completed under 7 minutes.  

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Quick Summary

Dynamic bond funds are debt mutual funds that adjust allocations between short-term and long-term bonds based on changing interest rates. Managed by fund managers, they aim to provide optimal returns in different market conditions. Investors with moderate risk tolerance and a 3-5 year horizon can consider investing. Factors affecting returns include the asset manager's view on interest rates, macroeconomic influences, risks involved, and tax-efficiency.

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