FundsIndia explains: Dynamic Bond funds

Dynamic bond funds are a category of debt funds meant for medium to long-term holding. They invest in various types of bonds that include gilts and corporate bonds with varying maturities.

How they operate
As the name suggests , these funds are dynamic in nature with respect to both their composition and maturity profile. They consist of a mix of Government securities as well as corporate bonds. They are also dynamic in the way they react to interest rate movements or anticipated rate changes. Based on the interest rate outlook of the fund manager, these funds have flexibility to invest in instruments with long-term or short-term residual maturity. As previously discussed in the post on gilt funds, gilt funds primarily generate returns through duration play while other corporate bond funds such as short-term bond funds and income funds generate returns through an accrual strategy.

Dynamic bond funds on the other hand pick the best of both the worlds. Let us see how.

We already know that the prices of bonds are inversely proportional to the movement of interest rates in the economy, i.e. as interest rates head down, the prices of the bonds move up and vice versa.
Hence in a falling interest rate scenario, the fund manager of a dynamic bond fund will tend to increase the holding of long term instruments – typically gilts -in the portfolio to generate capital appreciation. This is known as playing the duration strategy. The fund will therefore predominantly hold gilts and also diversify it with some medium and short-term corporate bonds. As interest rates fall, the long-term gilts in the portfolio see a rally in prices and aids returns. The corporate bonds too rally; the extent of the rally being based on their residual maturity. The corporate bonds will also provide some steady accrual (interest income).

The opposite holds true as the interest rate cycle turns. The fund manager will reduce the holdings in gilts while reducing their maturity as well and look for medium to short-term instruments, typically corporate bonds, mostly traded and high-rated ones. While a transition towards shorter maturity ensures lower volatility, moving to corporate bonds also ensures higher accrual (interest income) than from gilts.

Let us look at how the above strategy is practised by funds. In early 2013 when the interest rates were still on the rise, the average maturities of dynamic bond funds were far lower than 10 years. But as the interest rates peaked by 2014 and as RBI indicated an accommodative stance on interest rates, fund managers increased the average maturity of these funds and by 2015 the average maturities of these funds were as high as 15 years (remember as interest rates go down, the prices of long term gilts increase the most and hence funds increase exposure to gilts). Currently at the bottom of the rate cycle, even as RBI had changed its stance on interest rates from accommodative to neutral, the average maturities of these funds are once again being reduced. The increase in the average maturity of these funds, when rates fell, happened through higher exposure to gilts. This was evident as long-term gilt exposure increased from 40% to 80% when rates fell and are currently at less than 50%.

How different are they from other bond funds
Dynamic bond funds are different from income funds and gilt funds. While income funds operate on a purely accrual strategy, dynamic bond funds generate returns through tactical shifts based on interest rate movements, especially in falling rate scenarios and use some accruals strategy in rising rate scenarios.

In a gilt fund, the fund manager has the flexibility to only vary the average maturity of the fund while staying invested in gilts at all points in time. On the other hand, dynamic bond funds have the flexibility to not only tweak the average maturity but also reduce gilt holding based on rate outlook.

Who should invest
Investors with at least a 2-3 year time frame, with risk appetite for some volatility and looking to make the best of interest rate changes can invest in these funds.