Dynamic funds for uncertain times
But investors can face losses in bond funds, if the fund manager gets his interest-rate calls wrong
When interest rates are expected to move up, the debt fund investor should ideally move into shorter-duration funds to curb his capital losses. On the other hand, when interest rates are on the downswing, he should move (at least a part of his portfolio) into longer-duration funds to make higher capital gains. But what about times when the outlook on interestrates is uncertain and rates could move in either direction? That’s when investors should opt for dynamic bond funds.
To combat the ongoing phase of economic slowdown and revitalise the economy, the Reserve Bank of India (RBI) has cut rates in the past five successive monetary policy review meetings. These cuts have brought the repo rate down by a cumulative 135 basis points (bps) to 5.15 per cent. Further, the central bank has said that the stance of monetary policy will be kept “accommodative (for) as long as it is necessary to revive growth while ensuring that inflation remains within the target”.
The bond market reacted positively to the successive rate cuts. Bond yields have dropped. The yield on the 10-year G-sec, which was hovering at around 7.8 per cent in October 2018, eased to about 6.4 per cent around the August bi-monthly monetary policy review meeting.
Yields hardening now: In the past two months—august and September—the benchmark yield has hardened by nearly 30 bps on concerns that the government may miss its fiscal deficit target. Several measures announced by the government in August-september to revive economic growth, particularly the slashing of corporate tax rates, are expected to weigh on the fiscal deficit target.
The minutes of the last monetary policy meeting (held in October 2019) showed that certain members of the Monetary Policy Committee (MPC) were of the view that the impact on the fiscal deficit target, which is 3.3 per cent of the GDP for the current fiscal year, would be limited. They felt that assuming tax collections are in line with the budgeted target, the fiscal deficit would rise by 20 bps at the most beyond the targeted level.
But the fact of the matter is that tax collections are way off the mark. Disinvestments are also behind the target of ~1.05 lakh crore. Therefore, in the current scenario of an economic slowdown, it is likely that the fiscal deficit may be breached by much more, even after accounting for the ~1,76,051 crore surplus from the RBI. The fixed-income fund manager at our fund house expects the fiscal deficit to swell by 30-40 bps above the target. If that happens, yields could harden.
Uncertain outlook: The minutes of the RBI’S monetary policy signal we could see more rate cuts as there is still some policy space to address growth concerns. At the same time, the RBI will also keep a close eye on inflation. Another 25-bps policy repo rate cut appears likely in the next monetary policy statement scheduled for December 2019. But beyond that, the RBI may also be compelled to look at the interests of depositors. So, although we seem to be in the last leg of a rate-cut cycle, policy repo rates could move either way after a period of time. Dynamic bond funds are a category that is well suited for this kind of an uncertain environment.
Flexible mandate: A dynamic bond fund holds the mandate to invest across durations: short-term, medium-term, and long-term. It has the flexibility to adjust the duration of the portfolio to benefit from any possible changes in the interest-rate scenario. A dynamic bond fund could move into short-term instruments, such as commercial paper (CP) and certificates of deposit (CDS), or longterm instruments, such as corporate bonds and gilt securities, depending on the fund manager's interestrate outlook.
The main purpose of a dynamic fund is to optimise returns, in both falling and rising markets. The price of bonds moves in an inverse direction vis-à-vis interest rates. When rates fall, bond prices rise, and vice-aversa. Since dynamic bond funds invest across durations, their risk profile, as well as the returns they generate, can be quite different from that of other debt mutual funds.
A dynamic bond fund carries moderate-to-high risk. Therefore, only investors who are willing to take high risk and have an investment time horizon of three to five years should opt for these funds.
Fund selection matters: Only a handful of dynamic bond funds have performed well across time frames. The category average trailing returns over the past three years and five years stand at around 6 per cent and 8.50 per cent, respectively.
Your financial advisor or you need to assess the characteristics of the fund portfolio. The quality and type of debt that the fund manager has taken exposure to matters, as also the maturity profile of the papers.
Right for these times: As mentioned, a dynamic bond fund should be recommended only if the investor has a longer time horizon and is willing to take moderate-to-high risk. If interest rates move either way in this span of three to five years, and the fund management team is astute enough to change the duration of the debt papers held at the right juncture, then these funds can offer attractive returns to investors.
However, do not assume that dynamic bonds are entirely safe products. Both interest-rate risk and investment risk are relatively high in these funds. In addition, they can also be quite volatile. If interest rates move in a direction opposite to the fund manager’s expectations, the investor can face serious losses in these funds.
Independent financial advisors (IFAS) should recommend dynamic bond funds only after an in-depth study of portfolio characteristics and performance track record across interest-rate cycles.