What are Dynamic Bond Funds and How Do They Work?

Dynamic bond funds can offer optimal returns in any market scenario as it mainly depends upon the fund manager’s decision and management of the portfolio. In this article, we talk about dynamic bond funds, their working and pre-requisites in detail. 

What are Dynamic Bond Funds?

Dynamic bond funds are open-ended debt funds that are invested across a wide duration. True to its name, dynamic bond funds follow a dynamic approach in maturity profile and composition. The primary objective of a dynamic bond fund is to maintain optimal performance irrespective of the market scenario.

The fund’s performance is determined by the fund or portfolio manager of the dynamic funds. Since most debt funds typically consist of huge assets worth several crores, a big pause in between interest rates may take a big hit on the returns of the bond investors. Dynamic bonds act as a perfect alternative for those who wish to successfully ride the fluctuating interest cycle. Fund managers achieve this by dynamically trading instruments with varying maturity periods based on the expected interest rate changes.  

How do Dynamic Bonds work?

The flexible nature of dynamic bond funds enables investors to quickly switch between short, medium and long term securities. For instance, a falling interest rate scenario may call for investment in long-term funds and a rising interest situation will encourage the fund manager to invest in short-term instruments. Thus, the fund manager can mitigate capital loss risks of long term bonds by reducing the average maturity of the portfolio.

The fund manager trades bonds with different maturities depending upon the anticipation of interest rate changes. For instance, he can increase investment in short and medium-term securities while reducing holdings in long-term gilt funds. 

Moreover, the portfolio manager can invest in bonds that have a high market rating. For instance, investment in certain corporate bonds yields high accrual income. But occasionally the fund manager’s intuition about the market may go wrong resulting in losses from dynamic bonds.   

Features and Benefits of Dynamic Bond Funds

The following are some of the salient features of Dynamic Bond Fund.

No Investment Mandate

Like other funds, dynamic bonds do not carry debt or an investment mandate. For instance, some rules state that short term bonds must invest in short term securities only. But these rules do not apply for dynamic bonds as they can invest in long term securities even for a short period, even a month. The dynamic bond strategy is driven by interest rate changes rather than duration.

Macroeconomic factors    

Macroeconomic factors such as government policies, oil prices, fiscal deficit may have an impact on the bond returns. Hence, it is wise to invest for a longer duration to minimize the short term risks.

Risk of Losses

Like all other debt instruments, dynamic bond funds have a certain amount of risk but are still lower than short term funds as short term funds cannot leverage the duration strategy. Additionally, in short term funds, the portfolio manager may not be able to alter the portfolio as required which may have an impact on the returns.

Impact of interest rates

The dynamic bond rates have an inverse relationship with the interest rates. If the interest rates increase, the bond prices decrease and vice versa. Additionally, if the interest rates continue to fall further, the bond prices will be fixed based on the remaining maturity period. If the fund manager holds a few short and medium-term corporate bonds, they will generate additional interest income as well.

Taxation

The taxation policy for dynamic bonds is like any other debt funds. The short term capital gains are taxable at the regular income tax slab rate for individual income. This rate is typically 20% along with indexation benefit. Typically investors need to stay invested in dynamic bonds for 3-5 years. Dynamic bonds invested for at least 3 years are eligible for capital gains benefit. Dynamic bonds are ideal for investors who fall under the high tax bracket. 

Dynamic Fund Allocation

Dynamic bond funds give the investors the flexibility to invest in several securities across various durations without adhering to any debt mandates. The dynamic asset allocation feature lets them choose both short and long term securities without any limitations and take advantage of the respective interest rates. 

Role of the asset manager

The asset or fund manager’s role is the most crucial in the dynamic bonds’ performance. Since asset allocation of dynamic bonds is influenced by market rate changes, any incorrect move may impact the fund greatly. The fund manager must be up to date about the market scenario and predict accurately to get the optimal returns from the dynamic bond investment. 

Factors to Consider Before Investing in Dynamic Bond Funds

Given below are the things you must remember before choosing to invest in dynamic bond funds:

• Study the past performance of the funds. Analyze its annualized returns for at least the past 5 years before choosing the dynamic bond to invest in.
• Study how the dynamic bond performed during interest rate increase and varied market cycles.
• Check if the modified duration of the dynamic bond matches with the investor’s limit. If it does, it is advisable to choose that dynamic bond.
• Dynamic bonds must be chosen by investors with a longer investment horizon (at least 3 years). This is because short term returns are more volatile and sell stable.
• Dynamic bonds are a great source of additional income for investors who have sufficient funds in their portfolio. Investors who understand the benefits and risks of these funds can go for it. 

The Final word

Although dynamic bond funds offer the flexibility to the investor to invest across many durations and a wide credit spectrum, you must be aware that the success of this investment depends upon the fund manager’s outlook, interest rates and carries a high credit risk.