Dynamic bond funds: Trust manager who has navigated rate cycles properly

In mid-May, when the yield on the 10-year government security (G-Sec) had fallen below 7 per cent, Sneha Singh (name changed on request), 45, who works for an information technology company in Noida, had bet on longer-duration bond funds, believing rate cuts were imminent. But with yields climbing to around 7.38 per cent, she is despondent. A chartered accountant friend has suggested investing in a dynamic bond fund.   

Fund managers of dynamic bond funds, too, hold divergent views currently. While some have reduced the average maturity of their portfolios to 2.16 years (expecting a higher-for-longer rate regime), others have raised it to 18.9 years (hoping to gain from rate cuts).

The bullish view

Quantum Dynamic Bond Fund has an average maturity of 9.67 years, above the category average. Says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund: “Retail inflation is cooling off. We expect core inflation to come close to 4 per cent or lower over two-three months.”

While food prices remain volatile, they have not translated into persistently high household inflation expectations, the parameter the Reserve Bank of India (RBI) targets through its monetary policy. According to Pathak, the tightening part of the rate cycle is over in all likelihood. “As inflation cools off, the risk premium in the market will reduce,” he says. 

The inclusion of Indian G-Secs in the JP Morgan Government Bond Index-Emerging Markets could attract foreign portfolio investments (FPIs), once US treasuries and crude oil soften.

Crude oil poses a risk

The high price of crude oil (brent is currently at around $92 per barrel) could prevent inflation from declining. “If crude rises above $100 and sustains there, we will have to re-evaluate our position,” says Pathak.

High 10-year US treasury yield (currently at around 5 per cent) is perceived to be another risk factor, but fund managers say its impact on domestic yields has declined.  

Divergent views

Joydeep Sen, corporate trainer (debt markets) and author, expects the repo rate to remain stable in the near-term. “Yields could possibly ease sometime next year, either due to the RBI rate cuts or foreign portfolio investments in Indian bonds due to their inclusion in a foreign bond index, or both,” he says.

He adds that these two parameters are causing divergence in market participants’ views: timing of start of the rate-cut cycle, and whether foreign investments will materialise.

Betting on rate movements 

Investors unsure about the direction of interest rates may opt for a dynamic bond fund. “Their fund managers change portfolio maturity in line with their views on interest rates. When they expect rates to fall, they increase the portfolio maturity, and vice versa,” says Sen. He adds that if the fund manager gets his calls right, these funds can deliver attractive returns.

They are all-season funds. “Investors don’t need to time their entry and exit into them,” says Abhishek Kumar, Sebi-registered investment advisor and founder, SahajMoney. Adds Pathak: “By remaining invested in them for the long term, investors can defer their tax liability.”

Calls can go wrong  

The performance of these funds depends heavily on the fund manager’s views. If a fund manager raises portfolio maturity expecting a rate cut, but rates rise higher, his fund’s return would take a hit. “Wrong calls can be disastrous for the fund’s performance,” says Kumar.

Investors can experience high volatility, especially when fund managers run high duration.

How to select the right fund

Check the fund manager’s long-term (10-year or more) track record. “A manager who gets seven out of 10 calls right is considered good. Choose one who has performed well over multiple rate cycles,” says Sen.  

Pathak suggests examining performance when rates are rising. “Check the level of drawdown during those periods,” he says.

Examine the quality of the portfolio. “Don’t invest in a fund that takes a lot of credit risk,” says Kumar.  

The portfolio should be liquid. “Only then will the fund manager be able to react to the changing market environment,” says Pathak.  

These funds are meant for the long-term portion of the fixed-income portfolio. Enter them with at least a three- to five-year horizon.