Managing debt market volatility by investing in dynamic bond funds

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While debt as an asset class is relatively less volatile as compared to equity, we have seen a fair share of volatility in the debt markets in recent times. Inflationary concerns have led to a change in the monetary policy stance of central banks across the globe, including India.

We are in the midst of a rate hike cycle and the ever-evolving growth inflation dynamics globally has kept debt markets on their toes. While this volatility is here to stay for some time, it is important for investors to understand that sitting on the sidelines and waiting for the volatility to ease out can impact their overall portfolio returns and they can miss out on investing at higher yields.

There is usually confusion among investors whether to choose long or short duration funds and the opportune time to shift from one to the other. With changing market dynamics and timing difficulties, dynamic bond funds should be considered.

Dynamic bond funds are open-ended debt funds that have the flexibility to invest in securities of different maturities including money market instruments, medium/long bonds, and G-secs. These funds predominantly invest in high credit quality instruments as the focus is on generating returns through capital gains by capturing market movements rather than through an accrual income.

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These funds do not have any restriction in terms of average maturity or duration, and the fund manager can change the maturity of the fund based on his interpretation of the market dynamics and interest rate cycle. This means if the fund manager expects the interest rates to move up, they will reduce the average maturity of the portfolio and if interest rates are expected to move lower, the average maturity of the portfolio will be increased. This is because change in interest rates is inversely proportional to bond prices and longer maturity bonds have higher price impact from change in interest rates as compared to bonds having shorter maturity. So, with this dynamic management, the aim is to reduce the losses in times of rising interest rates by running a lower average maturity and generate capital gains in times of falling interest rates by maintaining a higher average maturity.

Further, as we are in the middle of a rate hike cycle with the potential of a further increase, investors can look at staggering their investments over the next six-12 months through systematic investment plans (SIPs).

Investing via SIP can help in managing volatility effectively as regular investments over a period of time help in distributing risk evenly. During a period of rising interest rates, staggering investments helps to smoothen volatility by accumulating higher units. These higher units then help in earning higher returns when the interest rate cycle reverses.

Let’s understand this better with an example. Consider a monthly SIP of 10,000 in Crisil Dynamic Bond Fund AIII Index from January 2010 to March 2012, which was a rate hiking cycle. Those who invested in a staggered manner during this period and stayed invested in the fund for more than three years, say till January 2015, they would have earned an extended internal rate of return of 9.2%. The value of their investments would have grown to 3.8 lakh as against a cumulative investment of 2.7 lakh.

While staggered investments help in distributing the risk and a dynamic duration management helps in reducing the impact of change in interest rates in the long-term, it is important to understand that this can also lead to higher volatility in the short term. Hence, it is advisable to invest in dynamic bond funds with an investment horizon of at least three years and more.

This allows dynamic bond funds to offer tax-efficient returns as compared to traditional investment avenues since debt mutual funds offer the benefit of indexation.

The long-term capital gains tax on investments held for more than 3 years is 20% post indexation (adjusting the investment for inflation) as compared to marginal tax rates in case of traditional investment avenues.

So, if you understand the risk and can stay patient during volatile times, systematic investments in debt funds can help you build a reasonable corpus over a period of time. The important aspect for any investment to yield returns is to stay invested and ride the current cycle to your financial goal.

DP Singh is deputy MD and chief business officer at SBI Mutual Fund

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