Dynamic Bond Funds helps to deal with volatility

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Actively managed debt schemes aim at both interest accrual and capital appreciation

 

Of late, there has been a lot of talk about the rate of interest and also the rate of inflation. This is because the two almost always move in tandem — mainly to keep the real rate of interest positive. This time, of the several types of debt funds available in the market, dynamic bond funds are gaining in popularity among investors. These are actively managed debt schemes in which the fund manager has the discretion to invest the corpus according to his/her outlook on the rate of interest going forward.

So, if he thinks that the rate of interest will go down over the next few months, or one-two years, he will shift his/her portfolio more towards long maturity debt instruments. On the other hand, if the outlook on rates is that of upwardly moving, he/she would shift towards short tenure instruments.

Before we move forward, a little primer on how bond prices and yield are inversely related will be of some help. For example, the Indian government sells a security of 10-year maturity (G-sec) at Rs 100 each and pays a rate of interest of 9% per annum (Rs 9 as interest). Now, say after a year, the rate of interest in the economy moves up to 10%. In such a scenario, anyone buying the G-sec paper of 10-year maturity sold the previous year would demand a higher rate, that is 10%.

But if the holders of that G-sec insist on selling the paper at its original price, that is Rs 100, he/she would hardly get any buyer. So, to sell that G-sec, he/she has to accept a lower price. Eventually, if the G-sec is sold at Rs 90, then the new holder will get Rs 9 as interest, but at his/her market price of Rs 90, this return (called the yield here) will be 10%.

 
A reverse is also true in the bond market. Suppose the market rate of interest goes down to say 8%, the price of the same G-sec will rise to about Rs 112 to adjust to the 9% return from the same paper to the current market yield. Because here, Rs 9 on Rs 112 is about an 8% yield. So, we can see that yield and price of a bond are inversely related.

In a dynamic bond fund, the fund manager takes a call on interest rates and invests accordingly. When the fund manager believes that the rate of interest in the economy is on a southward path, he/she would predominantly invest in long maturity bonds, G-secs, etc. On the other hand, he/she would increase investments in short term debt papers when the view is that the rate of interest rates would go northward.

The fund manager manages the duration in such a way that when the interest rate regime in softening, he shifts to longer maturity papers. These funds primarily aim at both accruals as well as capital appreciation. In the last one year, some of these funds have given returns of as high as 16%.

These funds are actively managed funds where a lot depend on the view of the fund manager. While the fund manager goes into longer maturity papers when the rate of interest is going down, he/she invests in shorter duration papers, mainly to protect the capital when the view on interest rate is reverse, that is of rising rate. The fund manager also has the leeway to keep the entire portion of corpus in cash and cash equivalents in periods of very high interest volatility.

Given these attributes, investors who are willing to accept some amount of volatility in their portfolio can invest in these funds. And usually the duration is about two-three years.

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