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If dynamic bond funds are meant to be managed dynamically—they increase their duration when interest rates fall and reduce it when interest rates rise—why have most of them lost out in the past 12-14 months? On an average, dynamic bond funds have lost 0.21% from November 2016 till date, when rates have risen. Short-term income funds returned 4.72%, in comparison. Are dynamic bond funds dead or is this just a temporary phase?

Dynamic bond funds are aggressive income funds where the fund manager can change the underlying portfolios drastically. Every debt fund is supposed to invest as per its mandate: so, short-term bond funds invest in shorter-tenured securities and long-term bond funds invest in longer-tenured ones. But dynamic bond funds don’t have such restriction. They can be long-term bond funds in one month and short-term in another, depending on where the interest rates are headed.

Since interest rates and bond prices move in opposite directions, a higher portfolio duration (a statistic that measures a bond portfolio’s sensitivity to interest rates; higher a portfolio’s maturity, higher its duration) is beneficial when rates are down. In these times, dynamic funds increase their duration. But if interest rates are rising, dynamic bond funds typically reduce their duration to cushion the impact of falling bond prices. Shorter tenured bonds are less volatile than longer-tenured bonds.

Maneesh Dangi, co-chief investment officer, Aditya Birla Sun Life Asset Management Co. Ltd, says dynamic funds do not predict interest rates. “They are reactionary. Nobody can consistently predict correctly where interest rates are headed… but more importantly, fund managers cannot catch the peak of the interest rate cycle or even the trough, to be able to catch the entire bull or bear market, respectively. It’s only when a certain trend is visible that they start changing their portfolio’s duration," says Dangi. Even though the 10-year government security’s (the debt market’s benchmark security) yield started to go up from around November 2016, Aditya Birla Sun Life Dynamic Bond Fund (ABDF) started sharply reducing its portfolio duration from around October 2017.

Do all dynamic funds do so? Not quite. There are many dynamic funds that reduced their portfolio duration far quickly when rates first started to go down at the end of 2016. From a duration of 8.38 years as of end November 2016, IDFC Dynamic Bond Fund reduced its duration to 5.76 years. And it has maintained its levels more or less, since. ABDF reduced its duration from 8.32 years (November 2016) to 7.47 years (April 2017), but drastically reduced it to 4.77 years by the end of January and 4.31 years by the end of February.

Debt market experts say that the rise in interest rates last year was sharper than usual. And that caught bond fund managers off guard. “The Reserve Bank of India last cut interest rates (repo rate) in August 2017 from 6.25% to 6%. Since then, even though it hasn’t yet hiked interest rates, its tone changed. Why? Because inflation, suddenly, went up; from 1.46% in June 2017 to 5.07% in January 2018. This, coupled with other factors like high fiscal deficit and the earlier stand-off between RBI and PSU Banks (now solved) led to a sharp hike in the 10-year G-Sec yields and hence bond prices in general came down," says Joydeep Sen, managing partner, Sen & Apte Consulting Services LLP, a wealth management firm. A rise in global crude oil prices also contributed to rising inflation.

Debt fund managers responded by selling long-tenured papers and buying more short-tenured papers, reducing their duration, but that wasn’t enough to stem the losses in dynamic funds in this period. They still underperformed short-term debt funds.

The question is: should you just invest in short-term debt funds and avoid dynamic funds altogether?

Fund managers say the performance of a dynamic fund should be assessed over a 3-5-year period. We compared the performance of a sample and prominent dynamic funds with their own fund houses’ short-term funds over 3- and 5-year time periods (see graphic). Over the 3-year time periods, dynamic funds outperformed short-term bond funds around 60-70% of the times. But over 5-year periods, dynamic funds outperformed short-term funds by almost 80-90%. Says Dangi: “Though dynamic funds are agile, it’s only when you see a cycle that you really see their performance. You should hold it for at least three years," he says.

Dynamic bond funds, though, come with risk. Sharp interest rate movements, like the one we saw in the second half of 2017, can sometimes erase a long-term track of a fund. As on February 2018-end, all the dynamic funds in our sample list underperformed their short-term funds over the past 3-year periods.

Short-term bond funds take lower risks but also give lower, yet stable returns. Dynamic funds can give much higher returns but they come with much higher risk as well. Avoid dynamic funds if your investment horizon is less than three years, and only if you don’t mind the volatility. As per the Securities and Exchange Board of India’s definition of various mutual fund categories, as per its latest scheme consolidation exercise that is underway at present, dynamic debt funds are free to decide their duration. “This means they are a function of solely the fund manager’s expertise," says Sen.

If you cannot stomach the volatility, stick with short-term debt funds.

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