Dynamic Bond Funds: Explained in Detail

6 mins read
by Angel One
Dynamic bond funds are the first choice for investors with limited risk tolerance. Let us delve into the realm of dynamic funds in this article.

Dynamic Bond Funds are mutual funds that invest in bonds that change in value over time. Government securities, corporate bonds, and other debt and money market instruments of varying durations are held by Dynamic Bond Funds, which are debt mutual funds that invest in debt and money market instruments. These funds are not restricted in terms of the tenure or maturity of the securities they invest in, as is the case with most mutual funds. Depending on their outlook for interest rates, the fund managers invest over durations. Dynamic bond funds are often more volatile than short- and medium-term debt funds, but they have the potential to deliver greater returns over a wide range of interest rate scenarios when held for long enough periods.

What is the duration of the funds invested in Dynamic bonds?

The Macaulay Duration is the weighted average number of years an investor must hold a position in a fixed income instrument until the current value of the fixed-income instrument’s cash flows matches the amount paid for the instrument, to put it another way. The Macaulay duration measures the weighted average term to maturity of the cash flows from a fixed-income asset. This measure is closely related to another duration measure known as Modified Duration (more usually referred to as simply duration), defined as the change in bond price for every one percentage point change in interest rate. In other words, the interest rate sensitivity of fixed income security is represented by the Modified Duration.

Unlike traditional bond funds, dynamic bond funds can invest over different durations. The tenure of a Dynamic Bond will be determined by the type of securities in which the fund manager invests and the fund manager’s expectations for interest rate movements. For example, if the fund manager anticipates that interest rates will fall in the future, they will invest in longer-term (longer duration) bonds to reap profits from the increase in their value. Assuming that the fund manager expects interest rates to rise, they will invest in shorter-term bonds to decrease interest rate risks while also reinvesting maturing bond proceeds at higher interest rates to minimise interest rate risks further.

Benefits of Dynamic Bond Funds

  • Flexibility: Dynamic bond funds have the flexibility to invest across various debt instruments with different maturities, credit qualities, and interest rate sensitivities. Fund managers can adjust the portfolio duration and allocation based on their outlook on interest rates and market conditions. 
  • Interest Rate Management: Dynamic bond funds can actively manage interest rate risk by adjusting the duration of the portfolio. When interest rates are expected to rise, the fund manager can reduce the portfolio duration to minimise potential losses. Conversely, when interest rates are expected to fall, they can increase duration to capture capital appreciation.
  • Potential for Higher Returns: By actively managing duration and credit risk, dynamic bond funds may generate higher returns compared to traditional fixed-income instruments like government bonds or fixed deposit accounts, especially during periods of changing interest rates.
  • Diversification: Dynamic bond funds invest in a diversified portfolio of debt instruments, including government securities, corporate bonds, money market instruments, and other fixed-income securities. This diversification helps spread risk across different issuers and sectors, reducing the impact of defaults or credit downgrades on the overall portfolio.
  • Income Generation: Dynamic bond funds typically offer regular income in the form of interest payments and dividends. This can be attractive for investors seeking a steady stream of income, such as retirees or those looking for passive income sources.
  • Potential for Capital Appreciation: In addition to generating income, dynamic bond funds also have the potential for capital appreciation as bond prices fluctuate in response to changes in interest rates and credit spreads. Skilled fund managers can capitalise on these price movements to enhance returns for investors.

How does the yield to maturity of dynamic bond funds differ from other bond funds?

The yield to maturity of a fixed income asset is the total return (interest payments plus maturity amount or face value) that may be expected if the security is kept until its maturity. In other terms, YTM is the internal rate of return (IRR) of an instrument that is held until maturity and in which all interest payments (coupons) are made on time and reinvested at the same rate as when the instrument was purchased.

Investors must understand the link between yields and bond maturities to comprehend the YTM characteristics of dynamic bond funds fully. A graph that depicts the connection between bond yields and bond maturities at any point in time throughout history is called a yield curve. In its most basic form, a yield curve is upward sloping, which means that the yields on long-term bonds are higher than those on shorter-term bonds (see the chart below). Assuming that interest rates will decline, the fund manager will invest in longer-term bonds, which will provide a higher yield. If the fund manager anticipates that interest rates will rise, they will invest in shorter-duration bonds, which will result in a lower yield.

What is the credit risk associated with Dynamic Bond Funds?

In addition to government securities, corporate bonds (non-convertible debentures) and other debt/money market instruments are the primary investment vehicles for emotional bonds. Government Bonds issued by the Central Government have Sovereign status, meaning there is no credit risk associated with them. Sovereign status is granted to bonds issued by state governments, which means there is no credit risk. Corporate bonds & debt/money market securities issued by private-sector issuers, on the other hand, are vulnerable to the risk of default.

Credit rating firms assess the credit risk associated with debt and money market assets, among other things. Increased credit risk is associated with higher-rated securities and vice versa. Lower-rated bonds offer greater yields, and some fund managers may choose to invest in lower-rated bonds to raise their income. However, as a result of this, the fund’s credit quality will deteriorate, resulting in increased credit risk. Before investing in a dynamic bond fund, investors should continually evaluate the credit quality of the non-G-Sec portion of the portfolio to ensure that they are comfortable with the credit quality.

Duration of investment in Dynamic Bond funds

Based on the interest rate outlook of the fund management, dynamic bond funds may have duration profiles that are very long in duration. The short-term performance of funds with extended duration profiles can be highly variable. As a result, investors in dynamic bond funds should always plan on holding their investments for an extended period. Interest rates are continually in a state of fluctuation. Different interest rate cycles will occur over sufficiently lengthy investment periods (at least three years), and you will earn higher returns on your assets due to these cycles. Furthermore, if you can hold onto your investment for three years or longer, you will be eligible for long-term capital gains taxation.

Investors in Dynamic Bond Funds come from a variety of backgrounds.

  • Investors seeking the best possible returns in a variety of interest rate scenarios
  • Investors with a moderate appetite for risk
  • Investors who can commit to a minimum of three years.

Before making any investments, investors should contact their financial experts.

Taxation of Dynamic Bond Fund in India

Dynamic bond funds, like other debt funds in India, are subjected to taxation based on the holding period. Here’s a breakdown:

Short-Term Capital Gains (STCG)

  • Applies to units held for less than 3 years.
  • Gains are taxed according to your income tax slab rate.
  • This can range from 5% to 30%, depending on your income bracket.

Long-Term Capital Gains (LTCG):

  • Applies to units held for more than 3 years.
  • Taxed at a flat rate of 20%.
  • An indexation benefit is available, which reduces the taxable gains by adjusting for inflation. This effectively lowers your tax liability.

Additional points to remember:

  • Dividends: Dividends received from dynamic bond funds are added to your income and taxed according to your income tax slab rate.
  • Tax on Reinvestment: Dividends are not taxed at the time of reinvestment. They are taxed only when you redeem the units.

If the above information interests you, open a demat account with Angel One today for hassle-free process


Is it safe to invest in Dynamic bond funds?

Investing in dynamic bond funds carries a certain level of risk, like any other investment. However, they are generally considered safer compared to equity investments but riskier than traditional fixed deposits or government bonds. Dynamic bond funds invest in a mix of debt instruments, and their performance depends on factors such as interest rate movements, credit quality, and market conditions.

What are the advantages of the dynamic bond funds?

Dynamic bond funds offer several advantages, including:

  • Flexibility in adjusting the portfolio’s duration and allocation based on interest rate outlook and market conditions.
  • Potential for higher returns compared to traditional fixed-income instruments, especially during changing interest rate environments.
  • Diversification across various debt instruments, reducing the impact of defaults or credit downgrades.

What is the time period for the dynamic bond funds?

Dynamic bond funds do not have a fixed time period like fixed deposits or certain other investment products. Investors can hold dynamic bond fund units for as long as they desire, depending on their investment goals and risk appetite.

How does a dynamic bond fund work?

Dynamic bond funds invest in a diversified portfolio of debt instruments, including government securities, corporate bonds, money market instruments, and other fixed-income securities. Unlike traditional fixed-income funds with a fixed duration or maturity profile, dynamic bond funds have the flexibility to adjust the portfolio’s duration and allocation based on the fund manager’s outlook on interest rates and market conditions.