Invest in dynamic bond funds to navigate impact of interest rate cycle

They outshine short-duration funds: Fund managers

The Reserve Bank of India (RBI) has raised policy rates twice since May and expectations of further rate hikes are not ruled out. Against this backdrop, fund managers are advising investors to consider investments in dynamic bond funds — mutual fund (MF) schemes that take exposure to debt securities with wide-ranging maturities.

Fund managers of such schemes alter allocations depending on their interest-rate outlook.

“After more than a 100-basis point (bp) sell-off in the bond market over the past year, the return potential of debt funds has improved significantly. We suggest investors increase allocation to dynamic bond funds in a staggered manner with a two- to three-year holding period,” says Pankaj Pathak, fund manager-fixed income, Quantum MF.

In May, the RBI increased the rates by 40 bps and another 50 bps in its June monetary policy. As the central bank started increasing rates, yields on 10-year government securities, too, hardened.

Fund managers are not looking to increase maturities due to expectations of further rate hikes. At present, they see value in bonds maturing between three and five years.
 

If yields move up further, as expected by fund managers, medium- to short-duration funds will be less volatile, compared to long-duration ones.

“We used the recent rise in bond yields to deploy portfolio cash into three- to five-year government bonds. For the core portfolio, we continue to like three- to five-year maturity bonds, which, in our opinion, offer a critical balance between duration and accrual yield,” adds Pathak.

Typically, the prices of fixed-income securities are dictated by prevailing interest rates. Interest rates and prices are inversely proportional. When interest rates decline, the prices of fixed-income securities increase. Similarly, when interest rates are hiked, the prices of fixed-income securities come down.

In the past year, such funds, on average, have given returns of 2.02 per cent, while in the three-year period, they have managed to give returns of 5.6 per cent. Some funds in the category have given returns in the range of 3-6 per cent in the past year.

Dynamic bond funds are typically more volatile than short-duration and medium-duration debt funds. However, they also have the potential to give superior returns across different interest-rate scenarios over higher investment tenures.