Dynamic bond funds: At a crossroads

High or Low Duration: Which one will reward

Fund managers of several dynamic bond funds (DBF) are busy raising the duration of their schemes in anticipation of rate cuts soon. However, a few are still not going all out for high duration portfolio strategy. Here is what you should know while investing in a DBF.

The duration game

Duration measures how long it would take, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed-income portfolio’s price to changes in interest rates. When interest rates fall, the higher a bond’s duration, the more its price will rise.

Since DBFs allow maximum flexibility to the debt fund managers as they can decide on both the credit quality and the duration of the portfolio, these schemes can be actively managed depending on the view of the fund managers. Some fund managers actively change the duration of the scheme, whereas a few more choose less churn.

Also, there are schemes such as Nippon Dynamic Bond Fund and Axis Dynamic Bond Fund which offer roll-down strategy. The roll-down strategy calls for investing in a basket of bonds that mature around a particular moment of time due to relative attractiveness at the time of investment and holding on to it till the maturity of those bonds. Even the interest receipts are invested accordingly.

The actively managed DBFs aim to optimise the returns by primarily changing the scheme’s duration taking into relative attractiveness from time to time. Many of these DBFs are seeing a lot of action. For example, SBI Dynamic Bond Fund has seen some aggressive changes in duration. Compared to 7.37 years Macaulay Duration in November 2022, the scheme gradually brought it down to 4.01 years as on March 31, 2023.

“While we are positive and constructive on duration, the recent reduction was on account of exposure to one year point of the curve and the end of the financial year, where we found better risk-reward,” says Dinesh Ahuja, Fund Manager-Fixed Income, SBI Mutual Fund. The fund has quickly enhanced the duration in April to 5.71 years.

That is not the only scheme raising duration. DSP Strategic Bond Fund has also enhanced the duration to 7.65 years, compared to 5.9 years in March 2023 and 0.97 years in December 2022. Sandeep Yadav, Head-Fixed Income, DSP Mutual Fund is bullish on long-duration strategy. “RBI is expected to continue to follow the US Federal Reserve on rate actions. A rate cut by US Federal Reserve sooner than expected should be a precursor for the RBI to cut rates,” he says.

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Existing interest rate hikes are expected to reduce the pace of growth of the Indian economy as well as inflation. That should pave the way for interest rates to go down.

“Our internal analysis indicates FY24 CPI to average around 5 percent and average growth to be in the range of 5.00 percent -5.50 percent. Thus, the macro dynamics for bonds is positive,” says Ahuja.

Cautionary tales

Though the expectation of interest rate cuts is very much in the air, not everyone is gunning for high duration in their DBF. The largest dynamic bond fund - ICICI Prudential All Seasons Bond Fund, has a duration of 2.95 years as on April 21, 2023. “The shorter end looks better than the longer end, as the curve is flat at this point in time. Given that we are in a mid-cycle; we do not see a significant benefit to investing in longer-duration assets at this point in time. However, we may trade long duration tactically,” says Manish Banthia, Deputy CIO- Fixed Income, ICICI Prudential Mutual Fund.

Put simply, there is not much difference in the yields quoted on short as well as long-tenured bonds. It makes sense to stay invested in short-term bonds. If the interest rates move favourably, long-tenured bonds can be added later.

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A look at the minutes of the MPC meeting released last week also made it clear that the pause in interest rate hikes announced by RBI is more tactical. It does not indicate the end of the monetary tightening cycle.

“The cumulative impact of our monetary policy actions over the last one year is still unfolding and needs to be monitored closely. Inflation for 2023-24 is projected to soften but the disinflation towards the target is likely to be slow and protracted. The projected inflation in Q4:2023-24 at 5.2 per cent would still be well above the target. Therefore, at this juncture, we have to persevere with our focus on bringing about a durable moderation in inflation and at the same time give ourselves some time to monitor the impact of our past actions. I am, therefore, of the view that we do a tactical pause in this meeting of the MPC,” said Shaktikanta Das, Governor, RBI in the MPC minutes.

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Quantum Dynamic Bond Fund also runs a duration of 2.99 years. Pankaj Pathak, Fund Manager – Fixed Income, Quantum Mutual Fund does not see much upside in the near term. “The yields may remain in a narrow range for some time at least in the first half of this year. We may see some signals of rate cuts in the second half of the financial year,” he says.

ITI Dynamic Bond Fund also has kept the duration below 1 year since December 2022.

Avnish Jain, Head Fixed Income, Canara Robeco AMC says, “RBI MPC may remain in a pause mode, as inflation remains above their target of 4 percent for a large part of FY2024, as the central bank watches the trend of inflation trajectory. Rate cuts, if any, may be back-ended in FY2024.” Any sharp reversal of rates by the US Federal Reserve may influence RBI MPC to move earlier. However, if growth remains on track, we believe that RBI MPC is likely to remain on pause mode, he adds. The portfolio of Canara Robeco Dynamic Bond Fund has a duration of 3.19 years.

What should you do?

While the tug-of-war on the duration front will go on for some time, investors should not get carried away from diverse views in the financial markets. It pays to focus on your financial goals and investment needs.

DBFs, on an average, have given 5.15 percent returns over three years ended April 24, 2023, as per Value Research. About 25 DBFs put together manage assets worth Rs 27,446 crore.

Joydeep Sen, Corporate Trainer- Debt, says, “Investors keen on letting the fund managers decide on the duration of their fixed income portfolio can consider investments in dynamic bond funds. If they do it on their own then every change of stance, calls for a shift from one scheme to another, say from short duration to long duration or the other way round. These transactions attract tax liability, however, if done under a dynamic bond fund, then such shifts are tax efficient.”

Since these schemes allow maximum flexibility to the fund manager, you should check the PRCM -potential risk class matrix of these schemes. While AIII indicates low credit risk and high duration risk, BIII and CIII indicate a relatively higher degree of credit risk along with high duration risk. Investors should choose in line with their risk-taking ability.

These schemes may work in the medium to long term as the fund manager is expected to alter the portfolio composition in line with their view. The scheme should ideally need to be held across an interest rate cycle. That means you should have a minimum of three years' view, the longer the better. Also, go for schemes that have demonstrated healthy risk-adjusted returns and fund manager stability.