Should you bet on dynamic bond funds in a rising interest rate scenario?

The interest rate hikes are hitting many debt mutual fund investors hard. RBI hiked the repo rate by half a percent this week. Money market pundits believe rates are likely to rise more. In this scenario, many mutual fund managers are recommending dynamic bond funds. However, many investors are wary of the track record of these schemes. Do these schemes make a good investment option for debt mutual fund investors at this point?

SEBI defines the dynamic bond funds as debt mutual funds which invest in debt and money market instruments like government securities, corporate bonds etc of different durations. These funds do not have any restriction with regards to duration or maturity of the securities they invest. This flexibility allows them to navigate various rate cycles with ease. That is why fund managers believe that these funds can be a good option in the current scenario.

However, the performance of the dynamic bond category says otherwise. The funds haven’t been doing well in the last few years, even after the RBI decided to start hiking rates this year. “Most of the dynamic bond funds run high portfolio duration; thus, are highly sensitive to interest rate changes. These funds do well when interest rates fall, and perform poorly in a rising interest rate environment. However, within the dynamic bond fund category, there is a large divergence between the performance of various schemes. So fund selection will play a key role in the dynamic bond fund,” says Pankaj Pathak, fund manager, Quantum Mutual Fund.

If you look closely at the dynamic bond fund category, you will see a very different picture. Even though the category is giving miniscule returns, schemes like UTI Dynamic Bond Fund are excelling. UTI Dynamic Bond Fund has offered 19.00% returns in one year, 7.43% returns in 6 months and 8.11% returns in 3 months. Franklin India Dynamic Accrual Fund has offered 6.65% returns in one year and Dynamic Debt Fund has posted 6.29% returns in one year.

Rest of the category has a lot of laggards. Most of the funds are offering low single-digit returns or negative returns. Fund managers believe that this is because of the bond yields moving up significantly – discounting future rate hikes. “There is an opportunity in the medium to long-duration bonds. Dynamic bond funds usually perform better in this kind of rate environment,” says Pankaj Pathak.

However, investors have to remember one crucial thing- the risk. The dynamic bond funds might be well placed in this scenario, but they have risk and might go through extreme volatility. That is the reason why mutual fund advisors are not convinced by these schemes.

“I am currently not recommending dynamic bond funds. These funds are like the flexi cap funds. However, to flex and maneuver in different debt instruments across the yield curve can be way more difficult and complicated. Liquidity can be a big issue and is immensely important in the debt market. Lack of liquidity in the corporate bond market can limit the flexibility of these funds. Hence they may not be able to maneuver across the yield curve efficiently. This can have a huge impact on the fund and its NAV. In the current volatile and rising yield scenario it is better to stick with simple accrual/roll down/target maturity funds somewhere at the shorter end of the yield curve to minimize drastic downside mark to market hit as the interest rate hike cycle is not yet peaked out and we are very much still in the middle of it,” suggests Rushabh Desai, Founder, Rupee with Rushabh Investment Services, an investment firm based in Mumbai.

If you have the risk appetite and want to earn extra returns by betting on risky debt funds, you can go for dynamic bond funds. Dynamic bond funds are meant for investors with at least three years of investment horizon. In the intermittent period, there could be high volatility in these funds. So, investors should be ready to face higher volatility.


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