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Are dynamic bond funds worth buying? (Relevant for GS Prelims, GS Mains Paper III)

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?

What are Dynamic bonds?
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.

What should you do?
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.

(Adapted from Live mint)

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