Dynamic Bond Funds are the Virat Kohli of Debt Funds. Confused? Let me explain.
Rohit Sharma, Cheteshwar Pujara or Virat Kohli – Who is the best batsman in India?
We all have our personal favourites but let’s answer this practically.
- Rohit Sharma is a great ODI batsman.
- Cheteshwar Pujara is a great test batsman.
- Virat Kohli is great in both the formats.
Ideally, you’d want someone who can win you both ODIs and test matches. So, your first pick will obviously be Virat Kohli.
Investors face the same dilemma in debt funds. They invest in short-term debt funds when interest rates are rising. Whereas in a falling interest rate scenario, they invest in long term debt funds.
But predicting whether the interest rates will rise or fall is not easy. You need to follow macro-economic trends and devote time and energy to correctly predict interest rate movements.
As a common investor, you might not have the time, resources or even the inclination to sit and study interest rate cycles.
But you’d still like to benefit from them. So, what do you do? Simple – You invest in the Virat Kohli of Debt Funds, Dynamic Bond Funds.
What are Dynamic Bond Funds?
Dynamic Bond Funds are neither short-term debt funds nor are they long-term debt funds.
Dynamic bond funds are a unique type of open-ended debt fund which invests in both short-term and long-term bonds. They change their underlying portfolio according to the current interest rate scenario.
As the name suggests, dynamic bond funds are dynamically managed. The fund manager plays a critical role in managing the underlying portfolio. Hence typically dynamic bond funds carry higher expense ratios.
The performance of a dynamic bond fund is solely dependent on the fund manager’s ability to predict interest rate movements.
This is because dynamic bond funds react aggressively to changing interest rate cycles. Let us explore how dynamic bond funds react to changing interest rates.
Dynamic Bond Funds & Interest Rate Cycles – An Indirect Relationship
We all know that interest rates and bond prices have an inverse relationship.
- When interest rates fall, bond prices increase
- When interest rates rise, bond prices decrease
Let us understand the relationship between interest rates and bond prices in detail.
Suppose the current interest rate in the market is 6%. A company ABC Ltd issues a bond. A bond is nothing but a loan taken by the company in exchange for interest rate.
In a bond, investor is the lender and the company is the borrower.
So, ABC Ltd issues a bond at 6.5% coupon (interest). As an investor, you will buy the bond since its offering higher interest rate than the market.
After a year, the interest rates rise to 7%.
But since you are invested in ABC Ltd Bond, you earn 0.5% less returns than the market.
Now, another company XYZ issues new bonds offering 7.5% interest.
What will you do?
Naturally, you will sell ABC Ltd.’s bond offering 6.5% interest. Like you, lakhs of investors will sell ABC Ltd.’s bonds.
Whenever there are more sellers than buyers, the price of the asset falls. So, the bond prices of ABC Ltd will fall.
Remember, the bond price of ABC Ltd fell because the interest rates rose from 6% to 7%. This proves that bond prices and interest rates have an inverse relationship.
As an individual investor, you might not have the expertise to predict interest rate movements. But you’d still like to earn money from this opportunity.
To cater to such investors, dynamic bond funds were launched. The fund manager plans to predict interest rate movements and invest accordingly.
In a falling interest rate scenario, dynamic bond funds invest in long-term bonds. This is done to lock-in higher interest rates for a long time period.
In a rising interest rate scenario, dynamic bond funds invest in short to medium-term bonds. These bonds have an average maturity of 2-3 years.
Who Should Invest in Dynamic Bond Funds?
The performance of dynamic bond funds is dependent on accurate prediction of interest rates. Hence dynamic bond funds carry high risk. Ideally, only investors with a medium-high risk tolerance should invest in dynamic bond funds.
Also, investors should try to match their investment horizon with the average maturity of the fund. Typically, investors with a 3-5 years’ time horizon should invest in dynamic bond funds.
Risks in Dynamic Bond Funds
Dynamic bond funds are debt funds. But they are not risk-free. The 2 major risks in dynamic bond funds are:
- Credit risk
- Interest rate risk
1. Credit risk is when the borrower fails to repay the principal or make interest payments. In the above example, ABC Ltd.’s failure to repay the borrowed money is known as credit risk.
The fund manager of dynamic bond fund is under pressure to deliver higher returns. Hence, they end up investing in bonds with poor credit ratings.
The recent Franklin Templeton debt fund crisis was a result of fund managers investing in poor credit quality bonds to earn higher returns.
2. Interest rate risk is inbuilt in dynamic bond funds. Because the fund manager is trying to guess the direction of interest rates, there is a 50-50 chance of success and loss. Hence dynamic funds carry very high interest rate risk.
Factors to Consider Before Investing in Dynamic Bond Funds
Apart from the above risks, you should also consider the following factors before investing in dynamic bond funds:
1. Average Maturity: Average maturity tells you when the underlying papers will mature. Dynamic bond funds come with varying average maturity.
For example: The average maturity of Aditya Birla Sun Life Dynamic Bond Fund is 3.57 years. But the average maturity if Axis Dynamic Bond Fund is 8.80 years!
It is important to match your investment horizon with the average maturity of a dynamic bond fund.
2. Credit Rating: Credit rating is crucial while investing in dynamic bond funds. As fund managers are free to invest across credit ratings, they can invest in poor rated papers for additional returns.
For example: Aditya Birla Sun Life Dynamic Bond Fund has only 40.61% exposure to AAA papers. 30.16% is in AA rated papers and 12.37% in A and Below papers. Such high exposure to AA and below A rated papers means the fund is extremely risky.
Whereas, Axis Dynamic Bond Fund has 0% in AA or Below A papers. It holds 70.74% in AAA, 25.81% in sovereign and 3.45% in cash. The fund is comparatively much safer than Aditya Birla Sun Life Dynamic Bond Fund.
An aggressive investor might invest in Aditya Birla Sun Life Dynamic Bond Fund. Whereas a moderately conservative investor might prefer Axis Dynamic Bond Fund.
3. Expense ratios: Dynamic bond funds are actively and dynamically managed. The fund manager plays a crucial role in managing the portfolio. Hence dynamic bond funds carry higher expense ratios. High expense ratio directly reduces your returns.
For example: The expense ratio of Aditya Birla Sun Life Dynamic Bond Fund is 1.66%. Whereas the expense ratio of Axis Dynamic Bond Fund is only 0.67%.
Hence it is important to see if the expense ratio of the fund is in line with its peers. A high expense ratio will reduce your portfolio returns.
4. Modified Duration: Modified duration is especially important when investing in dynamic bond funds. Modified duration measures how sensitive your fund is to interest rate changes.
Higher the modified duration, higher will be the sensitivity.
For example: The modified duration of Aditya Birla Sun Life Dynamic Bond Fund is 2.60 years. Whereas the modified duration for Axis Dynamic Bond Fund is 6.20 years.
This means that Axis Dynamic Bond Fund is more sensitive to interest rate changes.
5. Investment Horizon: Dynamic bond funds are suitable for investors with a 3-5-year time horizon. Investors with a shorter time frame should invest in liquid or ultra-short-term funds.
Investors are often confused between dynamic bond funds and corporate funds or gilt funds. These are all types of debt funds. But there is one massive difference between them.
Difference Between Dynamic Bond Funds and Corporate Bond Funds
Corporate bond funds have a strict mandate to invest majorly in AAA rated papers. Dynamic bond funds have no such mandate. Dynamic bond funds are free to invest across different credit rated papers. Hence dynamic bond funds carry higher risk than corporate bond funds.
Difference Between Dynamic Bond Funds and Gilt Funds
Gilt mutual funds only invest in securities issued by central or state governments. Dynamic funds do not have such restrictions. Dynamic bond funds can invest in securities issued by private companies. But gilt funds cannot do so. Hence while gilt funds carry zero credit risk, dynamic bond funds carry high credit risk.
How are Dynamic Bond Funds Taxed?
Dynamic bond funds are a type of open-ended debt fund. Hence dynamic bond funds follow debt fund taxation. The holding period of dynamic bond fund is 36 months or 3 years.
- If you sell your dynamic bond fund before 36 months, a short-term capital gains tax is applicable. The short-term gains are added to your income and taxed as per applicable tax slab.
- If you sell your dynamic bond fund after 36 months, a 20% with indexation long term capital gains tax is applicable.
Should Investors Invest in Dynamic Bond Funds?
Investors shouldn’t only invest in dynamic bond funds. Instead they should try to build an all-weather debt fund portfolio. Since dynamic bond funds try to predict interest rate movements, they carry high risk.
To combat this risk, investors should also invest in gilt funds or Bharat Bond ETFs. These funds mainly invest in government securities and hence will balance the riskiness of dynamic bond funds.
Also, only investors with a short-medium term investment horizon should invest in dynamic bond funds. Investors with more than 5 years’ time horizon should invest in floating rate or gilt funds. Investors with less than 2-3 years’ time horizon should invest in liquid funds, ultra-short term or money market funds.