Risk-averse investors generally prefer investing in safe investments, such as government securities, AAA-rates bonds, or debt funds, as they offer regular income. While it may be a suitable investment when the markets are stable, and interest rates are low, such investments do not generate enough returns to survive a volatile market environment. That’s where dynamic bond funds come into the picture.
But what is dynamic bond fund, and what are the benefits of investing in it? Let’s understand.
What are Dynamic Funds?
Dynamic mutual funds are a class of open-ended debt mutual funds, which are flexible in their portfolio positioning as per the ever-changing market conditions.
In other words, dynamic funds meaning involves a mutual fund scheme where asset allocations are adjusted based on the fund manager’s reading of the market conditions and interest rate dynamics.
Dynamic bond funds hold the potential to generate superior returns across different interest rate scenarios as the fund managers can dynamically alter the asset allocation. However, this also makes them highly volatile as compared to other short-duration and medium-duration debt funds.
[Duration is the weighted average number of years it’ll take for the present value of a bond’s cash flows to equate the price paid.]
Dynamic mutual funds shield against market downturns by minimising the losses incurred.
Which Securities do Dynamic Bond Funds Invest in?
Fund managers rely on interest rate projections to determine the asset allocation of a dynamic debt fund. These dynamic funds primarily invest in the following securities of varying durations:
- Government Securities and Bonds
- Bonds issued by banks
- Corporate Bonds (Non-convertible securities)
- Bonds issued by PSUs
How do Dynamic Funds Work?
A fund manager of a dynamic debt fund invests in multiple securities with different durations. These allocations are then adjusted as per his reading of the interest rate markets.
To illustrate, if the fund manager believes that interest rates will be hiked in the future, he will invest in short-term bonds to minimise exposure to interest rate risks. At the same time, he will re-invest the maturity proceeds at higher interest rates in the future.
Similarly, when a fund manager expects the interest rates to fall, he will invest in long-duration bonds, to profit from price appreciation. Thus, a dynamic funds manager will try to maximise returns by altering the duration of the dynamic fund as the market scenario changes.
Who Should Invest in Dynamic Funds?
Dynamic bonds are a suitable investment for investors looking for optimal returns across changing interest rate environments. Such investors should also have a moderate risk appetite.
Dynamic mutual funds’ investors must also stay invested for at least 3 to 5 years. This is because investors can experience multiple interest rate cycles over sufficiently long investment tenures, thereby earning better returns on their investments.
Staying invested for a longer duration also yields tax benefits, as the investors are liable to pay long-term capital gain (LTCG) tax on these returns. Investors should prefer going the SIP route for investing in dynamic funds.
Benefits of Investing in Dynamic Funds
The flexibility accorded to dynamic debt funds in investing in different-duration bonds results in several benefits. These are:
- Dynamic mutual funds can yield higher returns than short-term funds that are restricted by duration mandates prescribed by SEBI. They do so by investing in longer-duration bonds, which generate higher yields and price appreciation.
- Dynamic funds can better manage downside risks compared to long-duration funds that are unable to reduce their fund’s duration below the SEBI-prescribed limits. Hence, dynamic funds are less volatile when the interest rate scenario changes for the worse.
- Dynamic funds serve as a hedge in a constantly changing interest rate environment, thus generating optimal returns.
Taxation of Dynamic Funds
Dynamic funds are subject to similar tax implications as other debt mutual fund schemes. This means an STCG tax will be levied on an investment held for under 3 years while an LTCG of 20% will be applicable on a dynamic fund held for more than 3 years, after allowing for indexation. Dividends received will be taxed given the income tax slab applicable.
Things to Consider Before Investing in Dynamic Funds
Investors must keep the following factors in mind before choosing to invest in dynamic mutual funds:
The essential factor for determining whether a particular dynamic fund is a suitable investment is its track record. Investors must verify the fund has performed well across multiple interest rate scenarios over the past 5 years. This, thus, also means that investors should avoid investing in new fund offers (NFO) unless they are confident about the fund manager’s performance.
The asset allocation in dynamic bond funds is done based on the fund manager’s expectations about the likely changes in interest rates. Hence, these funds are subjected to market risks, as the policy environment can change drastically overnight, and they also depend on the fund manager’s ability to predict interest rate changes. Therefore, investors must verify whether the dynamic fund has managed to limit the downside risk whenever interest rates were raised in the past.
Dynamic funds are not suited to investors looking for short-term investments (under 3 years). So, individuals are recommended to invest in dynamic mutual funds only if their time horizon lasts at least 3 to 5 years. This will also make them eligible for indexation benefits on long-term gains generated by investing in dynamic funds.
Investors should keep track of the macro-environment, including oil prices, inflation rates, RBI’s policy, fiscal deficit, and government rules to better understand the potential impact of these changes on their dynamic funds’ performance.
To encapsulate, dynamic funds are an excellent addition to your portfolio if your aim is to earn sufficient returns while riding out the volatile market environment. However, you should extensively research dynamic bonds on their performance records and how these returns affect your tax incidence before jumping into dynamic bond investing.