Dynamic bond funds address interest rate uncertainty

The interest rate scenario in India has been uncertain for about a year now. The Reserve Bank of India's (RBI) latest comment on inflation being high reduces the possibility of interest rate cuts in the near future. After the cut in its key repo rate (the rate at which it lends to banks) by 50 bps in April 2012, the central bank's stance has been uncertain except for liquidity easing measures like a cut in cash reserve ratio and statutory liquidity ratio of banks. At this juncture of interest rate uncertainty, investors are unsure whether they should invest short-term or long-term. Dynamic bond funds, as the name suggested, are designed to dynamically alter allocations between long-term and short-term bonds to take advantage of the direction of interest rates.

 

 

 

 

 

 

 

The ambiguity regarding the pace and timing of further interest rate cuts has urged fund houses to take the middle path under dynamic bond funds. These funds dynamically alter allocations between long-term and short-term bonds to quickly take advantage of the direction of interest rates. This strategy helps benefit both during a fall and rise in interest rates. These funds can also shift their portfolios between government bonds and corporate bonds unlike the mandate for income funds and gilt funds.

 

 

 

 

 

Portfolio analysis

Of late, dynamic bond funds have become popular; average AUM rose threefold from Rs 5,104 cr in June 2010 to Rs 14,621 cr in June 2012 while long-term income funds grew by close to 50%. Here's why dynamic bond funds are the current favourite: A) In the recent past, they have provided superior returns in an uncertain interest rate environment. B) Fund managers have the flexibility to manage these funds as seen from the variation in the portfolio's average maturity. Chart 2 shows that average maturity of dynamic bond funds is lower than that of long-term bond funds, which helps the former manage interest rate risk better. C) Dynamic bond funds have maintained optimum credit quality of their debt investments. In the past five years, they invested 78% of total assets in sovereign and highest rated debt instruments (Gilt, AAA rated and P1+ papers).

In Chart 3, the period in the left circle (October 2008-January 2010) shows that the fund managers increased their exposure to long tenor debt papers as interest rates fell. Similarly, fund managers increased their exposure to short-term debt instruments when interest rates rose post February 2010 (right circle). Thus, fund managers actively managed the portfolio duration and benefitted from the interest rate swings.

Conclusion

It is difficult for retail investors to predict and take a call on interest rates. Dynamic bond funds fill this gap as fund managers take the call and tactically manage interest rate risk to earn superior returns. Past performance reveals that the category has outperformed 3 times in the last 5 calendar years vis-à-vis long term income funds and gilt funds as seen in Table 1. Further, this category, on an average, has outperformed long term income funds, gilt funds and the benchmark for the period up to 3 years as seen in Table 2. However, investors must note that these funds carry the inherent risk of the fund manager's call going wrong at times leading to underperformance. Hence, checking the track record of the fund house and the fund manager is important in selecting a good fund. Such funds also have a higher expense ratio (cost) due to excessive churning as compared with other long-term bond funds. A typical investment horizon for these funds is at least three years and is suitable for investors with a moderate risk-return profile. Most funds levy a 1% exit load in case of redemption within one year.