Unable to take duration call? Consider investing in a dynamic bond fund

But these funds can underperform if the fund manager's calls go wrong

The debt market could be volatile in the coming days. The interest-rate outlook could also change rapidly. Investors who find it difficult to deal with all this uncertainty may consider investing in a dynamic bond fund.

Inflation versus recession fears

At present, central banks are hiking interest rates and withdrawing liquidity to rein-in high inflation. This policy could tip some developed-world economies into a recession. This could, in turn, lead to a further fall in commodity prices, and hence inflation, leading to an early end to the rate-hike cycle. But if commodity prices continue to rise, central banks may have to raise rates at a faster pace.

Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund, says: “Currently, a tussle is on between two narratives — inflation and recession. The narrative could keep changing periodically, causing volatility.”

There’s another factor adding to investors’ dilemma. “Most are currently in shorter-duration funds to avoid the mark-to-market impact of rising rates. They will want to move into longer-duration funds when they think the repo rate has peaked, but may struggle to get the timing right,” says Arun Kumar, head of research, Fundsindia.com.

High level of flexibility

Many retail investors may not be equipped to handle these issues. Says Manish Banthia, senior fund manager, fixed-income, ICICI Prudential Asset Management Company: “Allocating investments in line with the evolving macros can be difficult for an investor, which is where a dynamic bond fund comes in handy.” Fund managers have in-house proprietary models tested over long periods for managing their funds. “Our model looks at current account and absolute G-Sec yield levels. Whenever the index level in the model starts moving into positive territory, the scheme begins to increase duration, and vice versa,” says Banthia.
 

Using the model, he says, takes away emotions from fund management. While other debt fund categories are constrained by the duration band they can operate within, dynamic bond funds enjoy complete freedom. Debt funds also enjoy a tax advantage. Says Joydeep Sen, corporate trainer (debt markets) and author: “If an investor moves from one fund to another, there is a tax incidence, which is higher if the holding period is less than three years. A fund does not attract taxes when its fund manager buys or sells securities to alter the portfolio duration.”

Calls can go wrong

One risk is that a fund manager’s rate calls can go  wrong. “Timing the interest rate cycle correctly is not easy, which is why delivering long-term outperformance has been a challenge in this category,” says Kumar. Expense ratios can be on the higher side, which raises the bar for fund managers to outperform.

Check past calls

To select the right fund, examine the fund manager’s track record. “View his performance in rising and falling interest-rate environments to see if he was able to increase and decrease portfolio duration at the right time. If the majority of his calls were right, go with him,” says Sen.

Pathak suggests avoiding fund managers who take too much credit risk. “This will unnecessarily raise portfolio risk. Lower credit quality papers also reduce portfolio liquidity, and hence the fund manager’s flexibility to alter duration,” he says.

Alternative options

Those who don’t want a dynamic bond fund may select a fund based on their investment horizon. If the horizon is less than one year, go with a liquid, ultrashort duration, low duration, or money market fund.

If the horizon is one to three years, split 50:50 between a low-duration and a short-duration fund. According to Kumar, investors with a horizon of more than three years should opt for a target maturity fund which allows them to almost lock in the return.

According to Sen, “Investors with a 10-year horizon may invest in a G-Sec fund. They will earn decent returns, though they may face interim volatility.”

If you go for a dynamic bond fund, invest for at least three years.