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What Are Dynamic Bond Funds?

Olga Robert

Dynamic Bond Funds are a category of debt mutual funds that are designed to take advantage of changing interest rates.

While there are different kinds of mutual funds in India, debt mutual funds invest in a mix of debt instruments or fixed income securities such as Government Securities, Corporate Bonds and other debt securities of different time horizons. One can earn from the fund through the interest income and the capital appreciation or depreciation in the value of the security invested in.

What are dynamic bond fund schemes?

Bond funds are affected by the interest rates in the market. When rates fall, long term bond funds make the most, however, higher rates cause them to lose badly. The dynamic bond funds find a way to minimize the effect of the volatility in the bond market by allowing them to switch between short and long term bonds.

As the name suggests the composition and maturity profile of the scheme is dynamic. The idea is to deliver optimal returns when the market falls or rises by adjusting the duration. The fund manager's decision is vital and the fund could lose substantially if the duration call goes wrong.

There are instances where the interest rates does not change for a substantial amount of time, hurting income earning potential of the bond investor. These dynamic bond funds allow the fund managers to play with interest cycles by trading instruments of different maturity periods as per their anticipation of change in rates.

How do dynamic bond schemes work?

According to SEBI, dynamic bond funds are open-ended debt schemes investing across duration. These schemes allow the fund manager to switch between long and short term securities in a short period of time. So when the fund management company feels that the interest rate cycle is going to fall, it can increase the tenure of the fund by investing in long term instruments like gilts.

The major factors that would affect the fund's performance:

  • Fund managers: It all depends on the fund manager's anticipation of how the interest rates will move. If their guess goes wrong, it will affect the profits significantly.
  • Economic factors: Change in oil prices, change in governmental policies, change in rules of the regulators like SEBI, trade wars, etc affect the interest rates as well as the way in which the fund house works.
  • Interest rates: Bond prices are inversely related to the interest rates. When their interest rates rise, the price of the bond falls. The rally or fall in the bond prices are further dependent on the maturity period of the bond.

Should you invest?

It is good for investors who wish to put their money on bonds but do not want to take calls on changing interest rates. These are meant for moderate risk taking segments of investors as the fund manager will invest in both short and long term bonds. There is an element of risk involved and may not be idle for a conservative investor.

If you wish to invest in dynamic bond funds, check the performance of the fund house that you choose over the period of at least 5 years. Also check how the fund manager managed the fund and limited its downside at a time when the interest rates increased. Avoid new fund offers and go for a fund that has a previous track record that you can check.

Ideally, stay invested in these bonds for a period of at least 3 years. Investments in these schemes for 3 years or more qualify for long term capital gain (LTCG) tax at the rate of 20 percent with indexation benefit. When redeemed within 3 years from the date of purchase, short-term capital gain (STCG) tax will be applicable on the income based on the tax slab that you fall under.

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