The past few months have seen heightened uncertainty in interest rate movements. While the Reserve Bank of India reduced the repo rate, its key lending rate, by 50 basis points in its annual review of the monetary policy in April, it has kept the same unchanged thereafter. While on the one hand, interest rates are expected to decline over the medium term, there is less clarity on the pace of this decline.
Investors can take advantage of a secular decline in interest rates by investing in long-term income funds as yields and prices/NAVs (net asset values) are inversely correlated. When yields fall, prices or NAVs rise and such funds give superior returns. However, the uncertainty on the interest rate front has created an opportunity for dynamic bond funds.
Dynamic bond funds, unlike traditional long-term income funds, can invest 100 per cent of their portfolio into either debt or money market instruments based on the prevailing interest rate scenario. Thus, dynamic bond funds enjoy the flexibility to manage interest rate risk better by moving across maturities depending upon the interest rate view of the fund manager. Thus, a lower maturity is selected if interest rates are expected to be high and vice-versa.
SBI Dynamic Bond Fund, managed by Dinesh Ahuja, is an open-ended income fund which has been ranked CRISIL Fund Rank 1 (in the top 10 percentile of its peer group) over the past three quarters as per the CRISIL Mutual Fund Rankings in the long-term income funds category. The fund has also had high growth in its assets under management (AUM) during the same period - from Rs 70 crore for the quarter ended December 2011 to Rs 1,256 crore for the quarter ended June 2012.
Risk-return attributes
The fund has outperformed its benchmark (CRISIL Composite Bond Fund Index) and the category across various time frames - three months (absolute), six months (absolute), one and two years on an annualised basis.
Over the past year, the fund has delivered an annualised return of 11 per cent, higher than that of the benchmark (nine per cent) and category (10 per cent). Thus, the fund has generated significant alpha over both the category and the benchmark.
Dynamic Duration Management
The fund's investment objective is to actively manage a portfolio of debt as well as money market instruments of various maturities on the basis of the expected interest rate scenario. Since November 2009, when this fund was renamed from Magnum NRI - Long Term Bond Plan to SBI Dynamic Bond Fund, the fund has taken active duration calls based on changing bond yields. For instance, the average maturity of the fund was 33 days at the end of October 2011 when the 10-year government security yield was at 9.02 per cent. In the next month, the average maturity was increased to eight years when the yields softened to 8.93 per cent (See Chart).
As seen above, yield movements can be volatile at times requiring the fund to churn its portfolio accordingly. Thus, it is very important to invest in highly liquid instruments to efficiently manage this churn. As per the latest CRISIL Mutual Fund Rankings, the fund is ranked in the top 30 percentile on the liquidity parameter indicating good liquidity in its portfolio relative to its peers. CRISIL's assessment of liquidity for debt securities is based on its internal assessment of each individual security in a fund portfolio.
The fund has also aggressively managed its duration or interest rate risk as compared to the category over the past two years (See Chart). While this could lead to higher volatility as compared to peers, the fund has outperformed on a risk adjusted basis as seen by the higher Sharpe ratio (measure of risk-adjusted performance). The fund has a Sharpe ratio of 3.75 against the category's 2.19, across two-year period.
Portfolio Analysis
The fund is more diversified compared to the category as the top 10 holdings of the fund form 76 per cent of its portfolio compared to 83 per cent of the category over the past year.
The fund has also changed its asset allocation based on market scenario. The fund increased the allocation to certificates of deposits (CD) when their yields started rising. From July 2010 to March 2011, the three-month CD rates rose from 7.1 per cent to 10.5 per cent. During this period, the fund increased the exposure to CDs from nil to 86 per cent. This was subsequently reduced to seven per cent when the CD rates fell to 9.25 per cent at the end of September 2011.
While the fund has dynamically managed its asset allocation, it has maintained a good portfolio credit quality. Over the past year, an average 97 per cent of its debt portfolio has been invested in highest rated papers and government securities.
CRISIL Research
