The resurgence of the coronavirus pandemic has cast doubts on the recovery of India’s economy. What with the second wave proving much worse than the previous one and localized lockdowns becoming the norm in various states in the country, businesses have been impacted and uncertainty hangs heavy as to when the pace of economic activities will resume normalcy.

In the light of this, the Reserve Bank of India’s outlook on interest rates is not crystal clear. As such, there is a high possibility that debt fund investments whose performances are dependent on how the RBI tinkers with interest rates will be affected although it would be an anomaly at this juncture to pinpoint a direction in which the swing can happen.

Until there is more clarity on the trend of interest rate movements, this can be a good time for investors to consider adding dynamic bond funds to their portfolio.

What are dynamic bond funds?

Dynamic bond funds can be defined as open-ended debt mutual funds that invest in securities across various durations. The main objective of dynamic bond funds is to generate optimum returns in both scenarios of rising and falling interest cycles. Dynamic funds do not carry any investment mandates and fund managers can invest in any debt security based on the movement of interest rates. The investment choices depend on fund managers’ decisions which is based on their expectations of changes in markets and interest rates.

How do dynamic bond funds work?

As the name suggests, these funds follow a dynamic approach in terms of the maturity of securities in the portfolio which means that the nature of these funds is such that they can be instantly switched between long term, mid-term and short-term securities. For instance, if a fund house postulates that interest rates are about to fall, it can increase the portfolio tenure. Alternatively, if their prediction is that the rates are not likely to fall any further, then the tenure of the portfolio is decreased. Thus fund managers trade bonds of varying maturity based on their analysis of expected interest movements and this is how they iron out the risk of capital losses due to rate fluctuations. This dynamic asset allocation helps investing in taking advantage of varying interest rate scenarios.

Things to keep in mind when investing in dynamic bond funds

• The fund manager plays a very important role in the performance of dynamic bond funds. The allocation and choice of investment tenures are a function of the fund manager’s perceptions of the interest rate movements and if their expectation of changes in interest rate turns out contrary to the RBI’s stance, it might affect the fund negatively. It is important to do your research on fund managers and check their performance over different interest rate cycles.
• These funds are good for investors who want to participate in bond markets but may not be savvy enough to make investment decisions by gauging interest rate cycles. An SIP approach can help you tackle volatility as well.
• Dynamic bond funds are taxed like debt funds –short term capital gains tax is levied on funds held up to three years based on the investor’s income tax slab while long term capital gains tax rate stands at 20% with indexation benefit.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.