All About Dynamic Bond Funds and How they Manage Interest Rate Risk

Fixed instruments such as bonds have the potential to yield relatively stable returns with lower risk and less volatility than equities. However, bonds also have risks that are unique to the fixed-income market. One such risk is interest rate risk, which can affect the value of your bond investments.

This is where dynamic bond funds come into play. These funds are designed to mitigate interest rate risk by dynamically adjusting their portfolios in response to changing interest rate environments, helping investors navigate changing arket conditions.

Let’s take a closer look at what dynamic bond funds are, and what factors you should consider before investing in them.

• Table of contents

1. What is interest rate risk?
2. What are dynamic bond funds?
3. How do dynamic bond funds manage interest rate risk?
4. Pros and cons of dynamic bond funds
5. Factors to consider before investing

What is interest rate risk?

Interest rate risk is the possibility that a bond’s price may fluctuate in response to interest rate movements. This is because there is an inverse relationship between bond prices and interest rates. When interest rates go up, the value of existing bonds with lower rates typically falls in the secondary market. This is because new bonds are now being issued with higher rates, making the older ones less attractive.

For example, if you hold a bond paying 5% interest and the market interest rate rises to 6%, new investors will prefer to buy the new bonds that offer the higher interest rate. To counter this, the issuer of the 5% bond will need to lower the bond’s face value to attract buyers. This decrease is reflected by a corresponding fall in the net asset value or NAV of the debt mutual fund investing in that security.

This is known as interest rate risk, and it can impact the returns from bond investments.

What are dynamic bond funds?

A dynamic bond fund is a type of debt mutual fund that has the flexibility to invest in bonds with varying maturities.

In contrast, many other debt mutual fund categories require the scheme to invest in fixed income securities of a certain maturity profile.

For instance, short duration funds must maintain a portfolio Macaulay duration of one year to three years, while long duration funds need to maintain a portfolio Macaulay duration of more than seven years.

Macaulay duration is the weighted average time it takes for an investor to get back the money invested in a bond, including the principal amount and interest payments. It is a measure of the bond’s sensitivity to interest rate movements. The higher the Macaulay duration, the higher the interest rate risk.

Dynamic bond funds have greater room to mitigate this risk than regular debt funds because they can flexibly adjust their portfolio based on the prevailing interest rate environment. The fund manager has the freedom to choose from short-term, medium-term, or long-term bonds, depending on where they see the best opportunities.

For example, if the fund manager expects interest rates to rise, they might shift the portfolio towards short-term bonds. On the other hand, if they anticipate a drop in interest rates, they may move towards long-term bonds to lock in higher return potential. This dynamic approach allows the fund to adapt to changing market conditions and potentially offer better returns than bond funds with a set duration.

How do dynamic bond funds manage interest rate risk?

Here are some ways in which dynamic bond funds seek to mitigate interest rate risk:

• Adjusting portfolio duration: When interest rates are expected to rise, the fund manager can reduce the portfolio’s duration by investing in shorter-term bonds. This minimises the impact of rising rates on the portfolio's value. On the other hand, when interest rates are expected to fall, the fund manager can increase the portfolio’s duration by investing in longer-term bonds to take advantage of the higher price appreciation that comes with declining interest rates.
• Diversification: Dynamic bond funds also diversify across different types of bonds—government securities, corporate bonds, and more. This diversification helps spread risk and optimise return potential.
• Active management: The active management approach allows the fund manager to respond quickly to changes in the market. This agility is crucial in managing interest rate risk effectively.

Pros and cons of dynamic bond funds

Like any other investment, dynamic bond funds have their own set of advantages and disadvantages.

Pros:

• Flexibility: A key advantage is the flexibility to adjust the portfolio based on interest rate movements, which can help in managing risk better than traditional bond funds.
• Potential for higher returns: By actively managing the portfolio, dynamic bond funds have the potential to generate higher returns, especially in volatile interest rate environments.
• Diversification: These funds often invest in a mix of bonds, which helps in spreading risk across different instruments.

Cons:

• Higher risk: While the fund manager has the flexibility to adjust the portfolio, there is also the risk that the predictions about interest rate movements may not always be accurate, leading to potential losses.
• Management fees: Dynamic bond funds involve a high degree of active management, which can result in a higher expense ratio.
• Complexity: For new investors, the concept of changing maturities and durations can be difficult to understand, making it a less straightforward investment option.

Factors to consider before investing in a dynamic bond fund

Before you invest in a dynamic bond fund, here are a few factors to consider:

• Investment horizon: These funds are generally better suited for medium to long-term investors who are looking to benefit from interest rate cycles.
• Fund manager’s track record: Because the performance of a dynamic bond fund heavily depends on the decisions made by the fund manager, it’s essential to look at the manager’s track record and their ability to manage interest rate risk effectively.
• Expense ratio: Keep an eye on the expense ratio of the fund, as higher fees can eat into your returns over time.

Conclusion

Dynamic bond funds seek to navigate interest rate movements by flexibly adjusting the portfolio’s duration in response to interest rates in the economy. While they come with certain risks, the potential for higher returns can make them appealing. By understanding how these funds work and considering your own financial goals and risk tolerance, you can decide whether a dynamic bond fund is suitable for your investment strategy. SIPs are a popular way to invest in mutual funds. Regardless of the chosen bond fund, an SIP goal calculator can help you plan your monthly SIP contributions to achieve your desired investment goals.

FAQs

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.