When interest rates get tough, invest in short-term funds such as liquid funds and once rates become stable, invest in aggressive bond funds
Debt fund investors are increasingly investing in dynamic bond funds at a time when interest rates are set to rise. In December, all mutual fund debt plans except dynamic bond funds, overnight funds and gilt funds with a constant duration of 10 years recorded net outflows. The overnight funds category recorded net inflows of Rs 4,731 crore, followed by buoyant bond funds with Rs 1,039 crore.
As dynamic bond funds shift allocations between short-term and long-term bonds, investors expect these funds to better adapt to interest rate movements and take advantage of fluctuating interest rates. This strategy is different from other categories of debt mutual funds which generally follow a pre-determined portfolio duration and hold the paper until maturity. Priti Rathi Gupta, founder of LXME, says investors have resorted to holding their funds in the most liquid form, such as overnight funds and cash reserves.
How Dynamic Bond Funds Work
According to the classification of the market regulator, dynamic bond funds are open-ended plans that invest over different durations and have the possibility of investing in short-term instruments such as commercial paper and certificates of deposit, or medium and long-term instruments such as corporate bonds and government securities. These funds are ideal for those who cannot make the right choices about fixed income investments based on the movement of interest rates. Investors should have an investment horizon of 3 to 5 years to invest in dynamic bond funds.
Before investing in a dynamic bond fund, you must ensure that the fund has demonstrated its ability to perform in several market scenarios and that it has succeeded in limiting the decline when interest rates have risen. Additionally, investors should be wary of dynamic bond funds with high credit risk and avoid funds that do not have high-quality liquid securities in their portfolio.
Ideal bond fund strategy now
Experts believe that in the current situation, an allocation to short-term debt funds and/or dynamic bond funds with low credit risk and a combination of liquidity to money market funds will benefit from the rise in interest rates.
Brijesh Damodaran, Managing Partner, BellWether Associates LLP, says with interest rates expected to rise, it will be prudent to invest in short term funds like cash and/or short term funds. “Once interest rates are more stable, investors may consider investing in dynamic bonds,” he says. He adds that liquidity and security of capital should be the two main reasons to consider when investing in debt funds and with yields tightening he recommends parking primarily in shorter duration funds and liquid funds.
When interest rates begin to rise, short-term debt securities perform better. Individual investors should keep in mind that dynamic bond funds are for those with a higher appetite for risk and a longer holding period. If an investor has a low risk profile and a short-term investment horizon, they should stick to short-term debt investments.
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