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Amidst the complex landscape of interest rate fluctuations, dynamic bond funds stand out as a versatile investment option. These funds grant fund managers the autonomy to navigate through different securities and maturity periods based on their market perspective.
In a rising interest rate environment, managers may lean towards short-term securities to mitigate the impact, while a declining rate scenario sees a pivot to long-term instruments for profit maximisation.
The dynamic bond fund category yielded an average return of 7.92% in 2023. With approximately 22 schemes in operation, the leading four dynamic bond funds have delivered returns above 7%, highlighting their efficacy in the current economic climate.
But what are dynamic funds and the benefits and risks associated with them? Let’s find out.
Understanding dynamic funds
According to SEBI’s classification, dynamic bond funds are open-ended debt funds that invest across various durations. In simple terms, they have the flexibility to invest in debt instruments with varying maturity periods. They modify the duration of the bonds depending on projections about interest rates.
They are permitted to put money into both short-term options like certificates of deposit (CD) and commercial paper (CP) and longer-term options like gilt securities and corporate bonds.
The main aim of a dynamic bond fund is usually to generate both a steady income and capital growth by proactively managing a portfolio composed of both short-term and long-term debt and money market instruments.
These are different from dynamic asset allocation funds, which invest in a mix of equity and debt.
But how do these mutual funds work?
When interest rates fall, long-term instruments generally perform well, whereas short-term instruments tend to excel when interest rates are on the rise.
That is why dynamic bond funds, anticipating hikes in interest rates, will lean towards short-term instruments. Conversely, they will favour long-term instruments if a fall in interest rates is expected.
In this way, dynamic mutual funds actively manage their portfolios based on their views of the interest rate cycle and the underlying trends in the debt market.
Benefits and risks of dynamic funds
Benefits
- These funds invest in various debt securities bearing diverse maturity periods, which helps in spreading risk.
- Dynamic funds possess the capability to amend their portfolios based on fluctuating market scenarios, potentially steering towards enhanced profits.
- They act as a shield to counter changing interest rates, striving to yield the most favourable returns by tweaking the duration of the investments.
- As debt instruments, these bonds offer more security compared to equity instruments. Despite the more subdued returns, these investments keep the investor’s capital safe and protected.
Risks
- Dynamic mutual funds can fluctuate due to unstable markets and the portfolio manager’s proficiency in anticipating rate shifts accurately.
- The dominant risk is the possible mistakes the portfolio manager might make, leading to financial losses if the duration strategy does not match changes in market rates.
- These dynamically changing funds might be more intricate and puzzling for ordinary investors due to their volatile nature.
- These bonds might also face credit risks when the issuers of the securities fail to meet their obligations to pay interest and the principal amount, which applies to the non-government security portion of the portfolio.
- Fund managers may face difficulties in selling underlying assets, thereby being adversely affected by liquidity risks.
Top dynamic bond funds in India
According to the five-year return as of 29-Feb-2024, the top 5 dynamic bond funds (direct plan) are:
| Scheme | Benchmark | Latest NAV | Return (%) |
| ICICI Prudential All Seasons Bond Fund | NIFTY Composite Debt Index B-III | 35.3782 | 8.57 |
| SBI Dynamic Bond Fund | CRISIL Dynamic Bond A-III Index | 34.8354 | 8.34 |
| Bandhan Dynamic Bond Fund | NIFTY Composite Debt Index A-III | 34.0083 | 8.20 |
| Kotak Dynamic Bond Fund | NIFTY Composite Debt Index B-III | 36.4097 | 8.04 |
| DSP Strategic Bond Fund | CRISIL Dynamic Bond B-III Index | 3,212.89 | 8.03 |
Is dynamic fund investment right for you?
Dynamic bond funds are prone to varying changes in the interest rates resulting in potential instability, typically noticed in a scenario of surging rates. Yet, the effects of such changes tend to diminish over time.
When considering the risk-return range of debt funds, dynamic bond funds occupy a position a bit towards the higher end of this range.
Due to this, these funds are deemed fit for investors with a willingness to endure short-term instability and with an investment timeframe that spans between 3 to 5 years.
Bottomline
Finally, it should not be presumed that investments in debt mutual funds come without risk or are completely safe. Several risks, like the risk linked to interest rates, credit risk, and liquidity risk, among others, are indeed a part of it.
Hence, it is crucial to choose debt schemes for investment that are in line with your risk tolerance, the time frame of your investment, and your investment goal.
FAQs
Dynamic bond funds are open-ended debt funds that invest across various durations. In simple terms, they have the flexibility to invest in debt instruments with varying maturity periods. They modify the duration of the bonds depending on projections about interest rates.
In the risk-return spectrum of debt funds, dynamic bond funds sit slightly towards the higher end, making them suitable for investors who can tolerate short-term volatility and have an investment horizon of 3 to 5 years.
Investments in debt funds, though, carry less risk, are not completely safe. Several risks, like the risk linked to interest rates, credit risk, and liquidity risk, among others, are indeed a part of it. So, before investing, you need to analyse these risks carefully.
In a scenario where interest rates decrease, long-term instruments typically outperform, while short-term instruments are likely to thrive when interest rates increase.
Therefore, dynamic bond funds, in anticipation of rising interest rates, switch towards short-term instruments. Conversely, they will prefer long-term instruments if a drop in interest rates is foreseen.
Dynamic mutual funds can fluctuate due to unstable markets and the portfolio manager’s proficiency in anticipating rate shifts accurately. If the portfolio manager’s assumption goes wrong, it could lead to financial losses.