Dynamic Bond Funds

Dynamic bond funds are open-ended debt mutual fund schemes that invest across duration. These funds have the flexibility to invest in short-term instruments, such as commercial paper (CP) and certificates of deposit (CD), as well as medium and long-term instruments, such as corporate bonds and gilt securities.

Their primary objective is to leverage changes in interest rates, which they view as opportunities to generate extra returns. Fund Managers achieve this by deftly adjusting the duration of bonds in the fund's portfolio, responding to prevailing interest rate trends.

These adjustments can lead to profiles with extended durations, resulting in volatile performance, especially in the short term. However, investors can potentially get higher returns if the fund gets its interest rate calls right.

As of April 2024, this fund category has average assets under management (AUM) of Rs 31,897.35 crore with 22 schemes, with the oldest being 27 years old, and the category ranked 10th in the list of open-ended debt funds according to the Association of Mutual Funds in India (AMFI).

Source: AMFI website as of April 2024

While you should identify your risk profile and plan your financial goals before investing in dynamic bond funds, here are some situations where they may fit in:

Alternative to Bank Fixed Deposits

As of April 2024, dynamic bond funds' annual return ranges from 6.25% to 8.57%. On the other hand, interest rates offered by large banks range between 6.6% to 7.1%. You can see that they give you better returns than bank fixed deposits, although they are market-linked and can fluctuate.

Note: While dynamic bond funds are good alternatives to bank fixed deposits, they are not insured like bank fixed deposits. Up to Rs. 5 lakh per bank account are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Moderate Risk Tolerance

Investors considering dynamic bond funds should have a moderate risk tolerance. While these funds offer potential for capital appreciation and income generation, they also carry interest rate and credit risk, which can lead to fluctuations in the fund's value.

Longer Investment Horizon

Dynamic bond funds may be more suitable for investors with a longer investment horizon who can withstand short-term market fluctuations. These funds may require patience as fund managers navigate changing market conditions.

Portfolio Diversification

Investors looking to diversify their portfolios beyond equities may include dynamic bond funds to spread risk. Investors with a lower risk tolerance who are uncomfortable with the volatility of stocks may find dynamic bond funds more in line with their risk preferences.

Dividend Taxation

Dynamic bond funds pay out dividends when you invest in their IDCW (Income Distribution Cum Withdrawal) option. Dividends are taxed at your marginal income tax rate, and TDS (Tax Deducted at Source) at 10% applies to dividends received more than Rs 5,000 per AMC per financial year.

Dynamic bond funds offer a range of benefits, as shown below.

Potential for Higher Returns

By actively managing the portfolio's duration and allocation, fund managers may have the opportunity to generate higher returns than traditional fixed-income funds during periods of interest rate volatility.

Professional Management

Experienced professionals manage these funds using market analysis, interest rate tracking, and credit risk assessment to maximise returns. For example, ICICI Prudential All Seasons Bond Fund is managed by Manish Banthia, who has 13 years of experience in fund management (as of April 2024).

Diversification

Dynamic bond funds invest in a diversified portfolio of bonds issued by different companies and industries. This diversification helps spread risk and reduces the impact of poor performance from any single issuer. For example, Nippon India Dynamic Bond Fund has invested over 100 government bonds to diversify its investments (as of April 2024).

Risk Mitigation

Dynamic bond funds are equipped to implement risk mitigation strategies. The fund manager can adjust the portfolio duration to reduce interest rate risk during rising rates or potentially increase it to benefit from falling rates.

Accessibility for Retail Investors

Dynamic bond funds make it easier for individual investors to access the bond market, which may require a larger investment if someone buys individual bonds, whereas users can start investing in these funds for as low as Rs 100. This accessibility is beneficial for retail investors.

Capital Appreciation Potential

Besides generating income, dynamic bond funds may also have the potential for capital appreciation when interest rates fall, increasing bond prices. Thus increasing the value of the investments.

Dynamic bond funds also face some drawbacks, as shown below.

Interest Rate Risk

Dynamic bond funds are exposed to interest rate risk. If interest rates rise, bond prices typically fall, leading to potential capital losses for investors. While fund managers aim to adjust the portfolio duration to mitigate this risk, the timing and accuracy of such adjustments are crucial.

Credit Risk

These funds may invest in lower-rated or riskier bonds to enhance returns. While this can lead to higher yields, it also exposes investors to higher credit risk.

Liquidity Risk

Some dynamic bond funds may invest in less liquid or harder-to-trade securities. In times of market stress, selling such securities may be challenging, potentially impacting the fund's ability to meet redemption requests.

Duration Risk

While dynamic management allows for adjustments to the portfolio's duration, the timing and accuracy of these adjustments are crucial. Incorrect duration calls could lead to underperformance or increased interest rate risk.

Complexity

Dynamic bond funds can be more complex than traditional fixed-income funds. Investors might find it challenging to understand the strategies employed by fund managers, leading to potential misunderstandings or misinterpretations of the fund's risk-return profile.

Market Risk

These funds are subject to general market risks, including fluctuations in interest rates, credit risk, and liquidity risk. Market conditions and economic factors can affect the performance of the fund.

Dynamic bond funds offer investors a flexible and professionally managed option within the debt mutual fund category by investing across various durations and types of debt instruments to capitalise on changing interest rate environments for potentially higher returns. While these funds provide a viable alternative to traditional bank fixed deposits and can enhance portfolio diversification, they also carry risks such as interest rate, credit, and market volatility. 

Therefore, they are best suited for investors with moderate risk tolerance and a longer investment horizon. Careful assessment of financial goals and understanding the fund strategies are crucial for aligning these investments with one's overall portfolio strategy.