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Investors should be aware that the rise and fall of interest rates affect the performance of a debt fund. Debt funds tend to earn better returns in a falling interest rate scenario whereas it is the complete opposite when the interest rate rises.
As an investor, you would want both scenarios to work for you. Dynamic Bond Funds do just that.
So, what is a Dynamic Bond Fund? How can you and your investment portfolio benefit from it?
What is a Dynamic Bond Fund
Dynamic Bond Fund Meaning: Fixed-income mutual funds that invest in money market instruments and debt instruments of different time durations are categorized as Dynamic Bond Funds. According to SEBI’s definition, Dynamic Bond Funds are open-ended debt schemes investing in various debt instruments of varying durations.
Dynamic Bond Funds do not follow a traditional investment approach. They follow a rigorous approach when it comes to the composition and maturity of securities of the investment portfolio.
Like every investment, the purpose of Dynamic Bond Funds is also to provide you with optimal returns. However, unlike other instruments of investment, Dynamic Bond Funds achieve this in rising as well as falling interest rate circumstances.
Before investing, it is important to know that there is always a time pause between interest rate changes. This pause affects the returns on your investment portfolio as well. This is where Dynamic Bond Funds can be a lucrative investment tool. They form an excellent alternative for those investors who want to generate better returns, irrespective of the interest rates.
The call to shift from a short-term to a long-term bond is taken by a fund manager. There might be a chance of a wrong call taken by the fund manager, which brings the risk factor.
Benefits of Dynamic Bonds
- Debt Fund mandate: Most investment tools have to follow a debt fund mandate. This means that a short-term debt fund has to invest in short-term securities. The same is applicable for long-term debt funds as well.
However, when it comes to a Dynamic Bond Fund, there is no debt fund mandate or constraint. Your investment portfolio can consist of long-term security and then change to short-term security. This is possible as Dynamic Bond Funds have the freedom to invest in securities of various composition and maturity as the strategy revolves around the changes in the market scenario.
- Risk factor: Dynamic Bond Funds work better than short-term funds as these funds do not have the advantage of duration strategy.
Duration strategy only works if your fund manager alters your investment portfolio at the right time. If there is a misjudgment, this can cause losses.
- Interest rates: The price of the bond falls when interest rates rise and vice-versa. Bond prices are inversely proportional to interest rates. When it comes to Dynamic Bond Funds, this change in the interest rate scenario can be beneficial as you have the option of shifting to a different investment instrument. The Dynamic bond fund that you hold can have an array of investments in debt instruments with varying maturities and gain potential returns.
- Macroeconomic Factors: Change in government policies, oil and gas prices, fiscal deficit, and so on, comprises macroeconomic factors. These factors have a huge impact on interest rates and changing market scenarios. Since interest rates affect the bond prices, Dynamic Bond Funds are also affected by this. Since the option of alternating between Debt Funds is the primary feature of Dynamic Bond Funds, risk is minimized.
- Tax Efficiency: The ideal duration to stay invested in Dynamic Bond Funds is of 3-5 years. Since this period is more than 36 months, the profits you receive from these Dynamic Bond Funds will be taxed at 20%, with the benefit of indexation. Tax efficient returns is one of the benefits of investing in Dynamic Bond Funds for investors.
How does a Dynamic Bond Fund Work
The principle of Dynamic Bond Funds is that you have the option to alternate between debt instruments of different tenures. You can switch from long-term to short-term to mid-term securities, quickly. This shift depends on the interest rate cycle.
Let’s say you have invested in long-term mutual funds. Your fund manager deems that the interest rate cycle is about to fall. At a time like this, he can increase the tenure of the portfolio. Similarly, if he thinks that the rates will fall, he can reduce the portfolio’s average maturity rate in a short period. This can be done to reduce the risk of capital losses on long-term debt bonds.
This is done to safeguard the investment and avoid any heavy losses caused by interest rate fluctuations. Apart from alternating between tenured bonds, asset managers of dynamic debt funds also invest in corporate bonds or gilts, depending on the anticipation of interest rate changes.
Who can Invest in Dynamic Bond Funds
Creating an investment portfolio requires some understanding of how the market works. Investors who can analyze interest rate movements and historical data can create their investment portfolios.
Dynamic Bond Funds work well for investors who are unable to make the right call on their investment, based on interest rate movements. Dynamic bonds also work best for investors who have an investment tenure of 3-5 years and have a moderate risk appetite.
As a new investor with a moderate risk appetite, an SIP (Systematic Investment Plan) approach will work. This allows such investors to counter the instability of changing interest rates.
Things to Keep in Mind When Investing in Dynamic Bond Funds
Before you choose to invest in a Dynamic Bond Fund, there are certain things you need to keep in mind:
- Check the historical performance of the fund. Analyze the data for the last five years and assess its performance across multiple market scenarios
- Understand how the fund was affected when interest rates were increasing and how it managed to limit the risk.
- While investing in Dynamic Bond Funds, investors often think of the modified duration. However, it is also important that the financial goal associated with the debt fund matches the outcome.
- Dynamic Bond Funds work best for investors who have a financial goal that can be achieved after three years. Dynamic Bond Funds work best when invested for a medium to longer duration.
- As an investor, Dynamic Bond Funds are a good investment option if you are looking for an additional source of income. However, understanding the risk is important before investing in Dynamic Bond Funds.
- While investing in Dynamic Bond Funds, it makes sense to select funds that have been running for at least five to eight years.
Frequently Asked Questions (FAQs)
1. What are Dynamic Bond Funds in India?
SEBI defines Dynamic Bond Funds as open-ended debt mutual funds that invest across duration. They follow a rigorous approach when it comes to the composition and maturity of securities of the investment portfolio. They have the flexibility to invest in long-term and short-term debt instruments.
2. Is it Good to Invest in a Dynamic Bond Fund?
Considered to be moderately risky, Dynamic Bond Funds are a good investment option for an additional source of income.
3. How do I Choose a Dynamic Bond Fund?
It is better to choose Dynamic Band funds that have a running period of at least five years. This will give you some data to analyze its historical performance, during interest rate fluctuations.
4. What is the Difference Between a Corporate Bond Fund and a Dynamic Bond Fund?
Dynamic Bond Funds alter investment portfolios between long and short-term bonds. They take advantage of the changing interest rate and generate optimal returns during the fluctuations.
