In its August Monetary Policy Committee Meeting, the RBI maintained status quo and left the policy repo rate and reverse repo rate unchanged at 4% and 3.35%, respectively. It has retained the accommodative stance to support economic growth.

Meanwhile, the RBI has maintained 9.5% as the projection for real GDP growth in FY 2021-22. However, it raised the inflation forecast for FY 2021-22 to 5.7% from 5.1% projected earlier. The inflation projection is close to the upper tolerance limit of 6%. Notably, RBI’s target is to keep inflation in a band of 2%-6%.

Furthermore, RBI has re-introduced the variable reverse repo rate (VRRR) fortnightly auctions since January 2021. It had temporarily stalled the auctions amid the pandemic. VRRR is a measure that the RBI takes to absorb excess liquidity from the banking system. It estimates that the current surplus liquidity is over 8 lakh crore. From September 2021 onwards, RBI will increase the amount absorbed through VRRR to Rs 4 lakh crore from Rs 2 lakh crore in January.

The higher inflation projection and normalization of liquidity measures indicate that the interest rate cycle may have bottomed out.

This does not mean there will be a hike in interest rate any time soon. There is still lot of uncertainty about when the trajectory of interest rate cycle will change. It is important to note that the risk to economy continues to persist because consumption growth is yet to pick up coupled with the fear of any potential adverse effects of the third COVID-19 wave.

As a result, RBI will continue to remain supportive to aid economic growth in the coming quarters. Accordingly, it is certain that any potential rate hike will be gradual and orderly to avoid any major disruption.

During uncertain interest rate environment, such as the one we are witnessing now, many investors prefer to invest in Dynamic Bond Funds.

Dynamic Bond Funds have the flexibility to shift investments between short term and long term bonds based on interest rate movement. This makes Dynamic Bond Funds different from other debt mutual fund categories that follow a pre-determined portfolio duration and aim to hold the instruments till maturity.

According to the SEBI categorisation norms, dynamic bond funds are open-ended dynamic debt schemes that can invest across durations. These funds have the flexibility to invest in short-term instruments such as commercial paper (CP) and certificates of deposit (CD), or medium to long-term instruments such as corporate bonds and gilt securities.

As you may be aware, interest rates and bond prices are inversely related. When the interest rates are falling, long-term debt instruments tend to perform well. On the other hand, in the rising interest rate scenario, short-term debt instruments tend to perform better.

If a dynamic bond fund anticipates an escalating interest rate scenario, it will increase holdings to short-term instruments and vice versa. Thus, it can take advantage of the changing rates and invest accordingly to create an all-season and tax-efficient portfolio.

So, is it the right time to invest in Dynamic Bond Funds?

Dynamic bond funds generally invest in fixed income instruments having a residual maturity of 3 years and above. Due to a longer maturity profile, Dynamic bond funds are sensitive to interest rate changes and thus, might witness some volatility, typically in a rising interest rate scenario. However, the impact of such fluctuations may fade out over time.

Since the fund managers have the leeway to invest across durations, they can use the fluctuation in interest rate movement to their advantage and reward investors with attractive returns. If you do not understand the interest rate movement and therefore find it difficult to create an all-season debt portfolio, investing in dynamic bond funds can be beneficial.

That said, the performance of the fund depends on the fund manager’s perception of the interest rate movement. If the fund manager fails to accurately gauge the movement of interest rates, or is unable to time the investment precisely, investors may suffer losses. Moreover, in case of an unanticipated movement in interest rate, the fund may witness high volatility in the short term.

While the impact of interest rate fluctuation may fade out over time, one should be wary of funds that can attract higher credit risk. Ideally, Dynamic Bond Funds should hold high-quality liquid securities in its portfolio. This will ensure that the fund manager can easily move from one duration bucket to another.

In the last couple of years, many funds in the category have increased their weightage to securities issued by government and quasi-government units, as the debt fund category grappled with rising instances of defaults and downgrades. However, several funds still hold significant allocation to moderate to low quality papers issued by Private issuers. As an investor, you should stay away from such funds because it can be prone to higher credit risk.

Besides, very few funds in the Dynamic Bond Funds category have efficiently capitalised on the flexibility to shift allocation in line with the interest rate movement. Therefore, it is important to choose Dynamic Bond Funds wisely.

Watch this short video on the lessons an investor can remember while investing in Debt Mutual Funds.

Here are the parameters to look into when selecting the best dynamic bond fund for your portfolio:

  1. The fund should have a decent track record of delivering adequate and stable returns across time horizons when compared to the category average and the benchmark index.
  2. Check if the fund has generated reasonable risk-adjusted returns by assessing risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.
  3. The fund’s portfolio should not be concentrated in a particular company or a group of companies.
  4. Choose a dynamic bond fund that invests predominantly in government and quasi-government securities.
  5. Avoid debt funds with more than 25% exposure to papers issued by private entities.
  6. Invest in a fund house that follows prudent investment and risk management process.
  7. Check the qualification and experience of the fund manager as well as the track record of schemes that they manage.

Investors having a higher risk appetite and longer time horizon of over 3 years can consider investing a small portion of their portfolio in dynamic bond funds, preferably the ones that hold predominant allocation to Government and Quasi Government securities. However, if you are an investor with a low risk profile and/or a short-term investment horizon, you should stay away from dynamic bond fund category.

For short-term debt investments, you could consider investing in debt funds that are relatively safer such as, Overnight Funds and Liquid Funds (with no exposure to private issuers). For those having moderate risk appetite and a time horizon of at least 2 to 3 years may consider Banking & PSU Debt Funds. Click here to know more about the strategy to follow when you invest in debt funds for the short term.

This article first appeared on PersonalFN here

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