Existing investors may hold on to dynamic bond funds HIGHER DURATION FUNDS HAVE UNDERPERFORMED OVER PAST 1 YEAR

New investors should opt largely for accrual-oriented funds which don’t bet on interest rate movements

Investment advisors were recommending dynamic bond funds to investors till as recently as August, when the Reserve Bank of India (RBI) had cut the repo rate by 25 basis points. These are funds where the fund manager changes the average duration of the portfolio actively to benefit from interest-rate changes. They are marketed as all-weather funds. Many of those who followed the experts’ advice would be a worried lot today. The three-month average return of dynamic bond funds is zero while the oneyear average is 2.76 per cent, according to data from Value Research.

The current underperformance of dynamic bond funds is due to the unanticipated hardening of interest rates. “In the past six months, the 10-year G-Sec yield has gone up from 6.30 per cent to around seven per cent,” says Mahendra Kumar Jajoo, head-fixed income, Mirae Asset Global Investments. Dynamic bond funds tend to have high average maturity and hence suffer more when rates rise.

Have fund managers of dynamic bond funds done a poor job of anticipating the rise in interest rates? Some experts believe one can’t draw that conclusion yet. “You may ask why fund managers continue to have such high average maturity in their portfolios when the 10-year G-Sec yield is spiking. The job of a dynamic bond fund is to capture the opportunity in rate movements. Unless fund managers are convinced that the rally in interest rates is entirely over (rates won’t fall any further), they can’t reduce the average maturity,” says Vidya Bala, head of research, Fundsindia.com. She adds that with the G-Sec at over seven per cent, many fund managers feel the interest rates may fall. Even if there is a slight fall, the returns of these funds will improve.

Existing investors shouldn’t exit these funds in haste. “If someone has invested with a three-year time frame, he should stay Category Gilt medium- and long-term Dynamic bond Income Short-term Liquid Ultra short-term invested. There could be a few months of negative or low returns, but eventually these funds will bounce back,” says Jajoo. There is a caveat though. This advice holds for investors who understand the volatility of dynamic bond funds and have the stomach and investment horizon to put up with it. Anyone who bought the product without fully understanding its risks should exit.

But what about fund houses’ claims that dynamic bond funds are allweather funds that investors can stick to in all scenarios? Some experts feel one should not get taken in by such claims. “The performance of a dynamic bond fund depends on the fund manager’s ability to anticipate interest rate movements and take positions in the portfolio ahead of rate changes. That is a difficult task,” says Nikhil Banerjee, co-founder, MintWalk. While a few skilled fund managers may be able to negotiate Return (%) 1-year 3-year 5-year 1.74 2.76 4.31 6.45 6.54 9.31 8.54 7.47 7.96 8.39 8.03 interest rate changes well, many funds in the category will underperform whenever there is an unanticipated rise in rates. “Take exposure to dynamic bond funds only if there is a very clear view on the direction of interest rates — that they are set to fall,” says Banerjee. Moreover, only financially savvy investors should invest in them.

Investors shifting from bank deposits to debt funds should invest entirely in shortterm debt funds. By holding these funds for three years and availing of the indexation benefit on taxation, they will earn 1-1.5 per cent more than fixed deposits. Any money needed within two years should also be invested in short-term debt funds. “Financially savvy investors with a longer horizon should allocate 50 per cent to short-term debt funds, 30-35 per cent to corporate bond funds and credit opportunity funds, and 1520 per cent to dynamic bond funds,” says Banerjee.