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While investors do not always want to invest in the debt funds, they are a safe bet in the falling interest rates cycle. Dynamic bond funds are debt mutual funds that alter allocations between short-term and long-term bonds. This helps them take advantage of changing interest rates. In this article, we will cover everything you need to know about dynamic bond funds.

  1. What are dynamic bond funds?
  2. Who should invest in dynamic bonds?
  3. Features & benefits of dynamic bond debt funds
  4. How a dynamic bond fund works
  5. Things to keep in mind while investing


1. Dynamic Bond Funds

The dynamic bond schemes, as the name suggests, are dynamic in terms of the composition and maturity profile. The objective of a dynamic bond fund is to deliver ‘optimal’ returns in both rising and falling market scenarios. It all depends on the fund manager’s decisions and portfolio management. 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, dynamic bond funds are an excellent alternative for those who wish to play to the interest rate cycle. 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.


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2. Who can invest in Dynamic Bond Funds?

The dynamic bond funds are ideal for investors who might not take the best calls based on interest movement. Investors with moderate risk appetite and  investment horizon of 3-5 years should invest in the dynamic bond funds.

An SIP (Systematic Investment Plan) approach will work better by allowing you to capture the volatility. However, one should always remember that the returns in dynamic bond funds are tied to the interest rates.


3. Features & Benefits of Dynamic Bonds

a. Role of Asset Manager

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

b. 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 minimize the short-term risks.

c. Risk Factors

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

d. Tax-Efficiency

Bond fund investors have to hold their investment 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.

e. Interest

The price of bonds is inversely proportional to the changing interest rate. So, if the interest rate is increasing, then the price 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.

f. 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


4. How a Dynamic Bond fund works

Dynamic bonds can switch from long-term to mid-term to short-term securities at short notice. 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 greater risks of capital losses on long-term bonds, it can reduce the portfolio’s average maturity abruptly. 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.


5. Things to keep in mind when Investing in Dynamic Bond Funds

a. 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.

b. See how the fund had managed to limit the downside when interest rates increased in the last few years.

c. Investors must go for a mix of income accrual funds for steady returns and dynamic bond funds as an additional income source.

d. Do not go for dynamic bonds if your investment horizon falls below three years.

e. Stay away from New Fund Offers (NFO) in dynamic bonds, and choose the one with a minimum of 5-year vintage and suitable 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 think it is too much time and effort to research and choose suitable debt funds, you can invest with ClearTax Save. We have done the homework and handpicked funds from the top fund houses in the country. Start investing – the entire investment process takes less than 7 minutes.


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