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In such a situation, theoretically, dynamic bond funds are best suited. Interest rates and bond prices are inversely related. When the interest rate is rising, bond prices fall and the fund manager should be able to decrease the duration of the bond; short-term bonds face a lower impact. And when the interest rate is falling he should be able to increase the duration of the bond. The fund manager can dynamically move from a fully invested situation to a cash position and various stages in between depending on his reading of the market. Generally, a long-term fund may run a passive exposure to long rates at all points in time. On the other hand, a dynamic fund would take tactical positions and run a combination of long and short end views.
But the critics out there are numerous. One argument levied against such funds is that the underlying assumption is that the fund manager will get his call right every single time. "It's like throwing a dart," says one fund manager. It is different when the fund manager goes long or short depending on a certain formula, but here it is a subjective call and he has to get it right every single time. Not a possible task.
Another grouse up against dynamic bond funds is that these funds are run pretty much like income funds. Even in a regular income fund, the average maturities can fluctuate widely, just as they do in dynamic funds.
How should an investor decide which fund to go for? One parameter is the direction of interest rates. There are way too many variables that go into determining the direction of interest rates - domestic and international. It is difficult for an experienced debt fund manager to make such a call, so one cannot even expect a retail investor to venture into that zone. Cycles are getting shorter. Markets are getting more volatile. If the days of easy predictability of bond prices and interest rates are over, how should an investor decide where to invest?
The second is the tenure of the investment. If an investor is looking to park his spare cash for three months, he would be making a big mistake in putting it in a medium-term gilt fund. He should pick a debt fund whose average maturity matches his investment horizon. But if he has money to spare for a year, he can consider a dynamic bond fund. Even today, Fixed Maturity Plans (FMPs) are good bets but there is a reinvestment risk. If the rate cycle turns by the time the FMP matures, the investor could lose out on an opportunity even if he then puts the money in a long-term bond fund. It would be wise to invest a portion of your debt allocation in an actively managed income fund.
Income fund - The risks
Interest rate risk
When interest rates rise, bond prices fall. So if the fund manager has his portfolio stacked with lower interest rate paper, the prices of his holdings will fall resulting in a lower net asset value (NAV). On the other hand, if interest rates fall, the prices of his holdings rise and so does his NAV.
The longer a bond's maturity, the greater the interest rate risk. A bond fund with a longer average maturity will see its NAV react more dramatically to changes in interest rates as the prices of the underlying bonds in the portfolio increase or decline.
Credit risk
Bonds carry the risk of default, meaning that the issuer is unable to make further interest or principal payments. They are rated by individual credit rating agencies to help describe the credit worthiness of the issuer. Higher the credit rating, lower the risk and lower the returns. Lower the credit rating, higher the risk and higher the return.
Liquidity risk
If the credit rating gets downgraded or the current interest rates are much higher than the coupon rate, then the bond would face liquidity issues because finding a buyer would no longer be easy. Liquidity risk describes the danger when one has to sell a bond in the secondary market but is unable to find a buyer.
While at any given point, all these risks exist, there are different phases in the interest rate cycle and in the history of the debt market where one particular type of risk has taken center stage. During the period from 1997 right through 2003, huge money was made on interest rates because during this period rates came down from 14 per cent to 5 per cent (10-year yields). From then on till 2008, money was made by taking credit risks when BBB rated companies were borrowing at 14-15 per cent. In 2008, it was liquidity risk that gained prominence though credit risk too had its place.
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