Dealing With Dynamic Bond Funds For Reducing Mkt Risks

The fund while taking advantage in the interest rate fluctuations provides a decent diversification strategy not just in the overall portfolio but within the debt portion of the portfolio

In most of the investors’ minds when the discussion mulls over mutual fund (MF), it invariably is understood as equity MF or equity-oriented MF. What many fail to comprehend that there is an equally strong asset being managed by the industry that amounts to about 40 per cent of the overall. Like the equity MF, there’re categories within the debt MF depending upon the type and the maturity of the securities.

Broadly, the debt MF are funds that deal predominantly in the debt securities i.e., which deal with loans of various types. The loan issuer could range from government to corporate and those which could be traded over the exchanges. These securities include treasury bills, govt bonds/gilts, corporate bonds, commercial papers, etc. Like any loan, there is an interest or coupon and tenure i.e., period till when the principal is repaid. These instruments are considered relatively less risky than equities as they generate consistent income through interest for a predefined time and hence are also defined as fixed income securities.

However, these do come up with their own set of risks like inflation/interest rate risk, liquidity risk and credit risk. The interest rates are directly proportional to inflation and interest rates inversely affect the bond prices. So, change in interest rates could add or reduce the prices. The liquidity risk derives out of the lack of enough capital i.e., liquidity to transact in these securities. This could hamper the buy and sell particularly when there is heavy selling during panics. Credit risk derives out of the default or counterparty risk of not able repay the principal. Each of these risks could be mitigated to an extent by the composition of the securities in the fund.

Dynamic bond funds are a category of debt funds which exhibit the flexibility in achieving this risk mitigation, to a large extent. The fund manager adjusts the duration in the portfolio to leverage shifts in the interest rates while continue to benefit from the consistent income. The combination of bonds across multiple bonds with varied maturities and credit quality makes them respond dynamically to the changing market situations.

This adaptive investment philosophy allows the fund manager to actively seek for maximising profits simultaneously reducing the risks. The most prominent feature of these funds is on how they switch from short to long-term securities and vice versa. So, if the fund believes that the interest rates have bottomed, then they would offset the possible losses by reducing their exposure to long-term bonds and allocating more to the short-term.

Despite the lower core inflation, the food inflation has been a big dampener for the central bank to cut rates. The policy divergence by the Reserve Bank of India (RBI) versus the developed world where the US Fed, ECB, etc. are on an aggressive rete cut regime, investing into long-term debt has turned uncertain. And it’s very challenging to predict the timing and quantum of these cuts into the future. Dynamic bond funds could be a tool to traverse through this muddle which could act like all-weather funds. The fund while taking advantage in the interest rate fluctuations provides a decent diversification strategy not just in the overall portfolio but within the debt portion of the portfolio. The core prioritisation remains in the income generation which is achieved through the coupon on the portfolio while benefiting from the gains due to the active trading of the bonds.

The bar-bell strategy achieved through the active management in the dynamic bond funds allow not only to reduce volatility but generate better returns in these volatile times. Despite the all-weather tag, the risk profile is a tad higher than conservative investors as there is a scope for volatility in the intermediate period and so investors with a horizon of three or more years are better suited. Also, this allows for better tax arbitrage as the realised gains are taxed at 20 per cent while the short term i.e., less than three years would be added to the income to be taxed accordingly.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])