How does a dynamic bond fund work ?

How does a dynamic bond fund work ?

In order to understand how a dynamic bond fund works, let us first understand a little bit about how changes in interest rates affect the stock market in Mumbai. RBI often changes the interest rates in response to economic activity and other global market influences: raising rates when the economy is overly strong, and lowering rates when the economy is sluggish, the rate at which banks borrow money, this has a ripple effect throughout the entire Indian economy. Rising or falling interest rates also affect consumer and business mind-set. When interest rates are rising, both businesses and consumers will cut back on spending since things become more expensive. This will cause companies earnings to decrease and stock prices to drop. When interest rates have fallen significantly, consumers and businesses will increase spending, which in turn causes stock prices to rise.

Interest rates changes also affect the price of bonds. An inverse association exists between bond prices and interest rates, as a consequence when interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. The longer the maturity of the bond, the more it will change in relation to interest rates. Businesses raise money via the sale of bonds. As interest rates move up, the cost of borrowing turns out to be more expensive. This means that the requirement for lower yield bonds will drop, causing their price to drop.

As interest rates fall, it becomes easier to borrow money, and many companies will issue new bonds to finance expansion and this will cause the demand for higher yielding bonds to increase forcing bond prices higher vice versa. Interest rates affect the Indian economy by influencing stock and bond interest rates, consumer and business spending, inflation, slowdowns and recessions.

The dynamic bond mutual fund is a type of open ended debt scheme that follows a dynamic approach in terms of maturity for investing across duration. The investment strategy of the mutual fund scheme would be to allocate funds across debt securities including government securities, debt derivatives and money market instruments of various maturities on the basis of the expected interest rate scenario. These types of mutual fund schemes enable investors to generate potential returns by shifting maturities of securities in the portfolio based on market scenarios.

Dynamic bond funds don’t have to follow any investment obligations like other debt funds. All bond funds are impacted by interest rates, these dynamic bond funds provide the fund manager the flexibility to adjust the allocations between short term and long term bonds to tide over the volatility in the bond market. In a falling interest rate scenario, they can invest in long duration securities. However, in an increasing interest rate scenario, they can invest in short duration securities. In other words, the portfolio manager can mitigate the risk of capital losses on long term bonds by reducing the portfolio’s average maturity when interest rates are rising. These debt funds follow an active duration management technique as a result of which the debt portfolio turnover could be high.

The overall performance of these dynamic funds rests on the fund managers expectations on the stock market, interest rates and interest rate mathematical models in the fund houses for predicting these changes that could result in dynamic bond mutual fund investors making or losing money. When ambiguous situations arise, in the movement trends of interest rates which are not noticeable or interest rates might go suddenly up or down sharply, then dynamic funds can take a performance hit. This is the biggest interest rate risk which exists in these dynamic bond mutual funds.

Dynamic bond funds are optimally meant for investors who are seeking regular income for a medium to long term investment horizon of around 4 to 5 years. Investors who do not have an advisor to guide them on the right time to enter these funds may choose a dynamic bond fund via a systematic investment plan (SIP) to manage the volatility and hope to obtain stable returns from interest rate movements over the economic cycle.

A mutual fund distributor or mutual fund advisor in Mumbai can also guide you on the performance of a dynamic bond fund over the last 5 years and may also check on the company’s background, management, fundamentals, and financials to mitigate the credit risks associated with investing in these types of dynamic bond mutual funds from various fund houses.

Dynamic bond mutual funds are taxed like any other debt fund. if redeemed within three years from the date of investment they are taxed at an individual’s income tax slabs. if redeemed after three years from the date of investment are taxed at 20% with the benefit of indexation.

The information, analysis and opinions expressed herein are for educational purposes only and are not intended to provide specific advice or recommendations for types of dynamic bond fund schemes. This material is not an offer, solicitation or recommendation to purchase any financial products or services or dynamic bond mutual funds. Always remember that all investments, including dynamic bond mutual fund investments carry some level of risk, including the potential loss of principal invested.