There is a case for some further policy rate easing in the Oct 4 RBI Policy review, driven by real positive interest rates, inflation being within target and GDP growth being sub-optimal. As and when the interest rate cycle turns, which is some time from now, existing investors may take a switch call.

Dynamic bond funds are ones that maintain portfolio maturity ideally on the longer side, but modulate the maturity profile as per the view on interest rate movements. That is to say, on a bullish view on interest rate movement, the fund manager would increase portfolio maturity to say 15 years to take advantage of fall in interest rates. On the other hand, when the view turns bearish and interest rates are expected to move up, the fund manager would turn defensive. He would reduce the portfolio maturity to, say, six years to minimise the adverse impact of interest rates moving up. These funds normally do not take credit risks, i.e., exposure to less-than-AAA rated securities and the dynamism is about varying the portfolio maturity to benefit from interest rate movements. The portfolio may include some government securities, which is the best credit quality available. The reason for taking exposure to G-Secs is that these are more liquid than corporate bonds and help build longer duration in the portfolio.

In a way, dynamic bond funds are invest-and-forget products because the fund manager is there to take portfolio positions as per the view on interest rate movement. However, to an extent, the investor needs to track what’s happening around him and take decisions on allocation to fund categories. A short-term bond fund would have a lower portfolio maturity than a dynamic bond fund as per the mandate / positioning of the fund, and in that sense is more defensive than a dynamic bond fund.

As and when the interest rate cycle seems to be turning around from bullish (i.e. expected to come down) to bearish (i.e. expected to move up), the investor also can be ‘dynamic’ by shifting from a long bond fund to a short bond fund. By doing this, he would be turning more defensive on a stable / bearish view on interest rate movement.

RBI monetary policy

So now we come to the crux of the issue: what is the view now? The next RBI Policy Review is scheduled for October 4. To look at the backdrop, in the review on February 8, 2017, the Monetary Policy Committee (MPC) had changed stance from accommodative to neutral. In the review on August 2, 2017, the MPC reduced the repo rate by 25 bps from 6.25% to 6%. Currently, inflation is within the targeted band, but showing upticks. GDP growth rate, at 5.7% for the quarter April-June 2017, is below par and there is an expectation that the central bank should give more monetary policy driven stimulus to spur growth.

However, given the latest upward bias in inflation, i.e., CPI at 3.36% and WPI at 3.24%, question marks on fiscal deficit target of 3.2% and the US Fed expected to unwind from October, it is likely that RBI would stay put on rate action on October 4. What are fund managers doing? A study of a basket of 22 dynamic bond funds shows that the average portfolio maturity of these funds is almost nine years, which shows that fund managers are moderately bullish. The maximum portfolio maturity in this basket is 16 years and on the lower side it is five years. Net-net, existing investors in dynamic bond funds can stay put. Even though the policy stance of the RBI MPC is neutral, there is a case for some further policy rate easing, driven by real positive interest rates, inflation being within target and GDP growth being sub-optimal. As and when the interest rate cycle turns, which is some time from now, existing investors may take a switch call.

For fresh investments in dynamic bond funds, the case is not strong. We are nearing the end of the policy rate easing cycle. Even if a fund manager takes the right calls in portfolio maturity maintenance, the alpha to be generated may not be substantial. Rather, the investor should be conservative right now as there is a tax angle in switching before completion of three years of holding.

Source: https://www.financialexpress.com/money/mutual-funds-what-should-investors-in-dynamic-bond-funds-do-find-out-the-way-forward/872111/