Managing debt market volatility by investing in dynamic bond funds

While debt as an asset class is relatively less volatile compared to equities, we have seen a good deal of volatility in debt markets of late. Inflation concerns have led to a change in the monetary policy stance of central banks around the world, including India.

We are in the midst of a rate hike cycle and ever-evolving inflationary growth dynamics globally have kept debt markets on their toes. While this volatility is here to stay for a while, it is important for investors to understand that sitting on the sidelines and waiting for the volatility to subside can affect the overall returns of their portfolio and may miss out on the opportunity to invest in higher returns.

There is often confusion among investors about whether to choose long or short duration funds and the right time to switch between them. With changing market dynamics and time constraints, dynamic bond funds should be considered.

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

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These funds do not have any restrictions in terms of average maturity or duration, and the fund manager may change the fund’s maturity based on its interpretation of market dynamics and the interest rate cycle. This means that if the fund manager expects interest rates to rise, it will reduce the average maturity of the portfolio and if interest rates are expected to fall, it will increase the average maturity of the portfolio. This is because the change in interest rates is inversely proportional to bond prices and bonds with longer maturities have a greater price impact due to the change in interest rates compared to bonds with longer maturities. shorter. Thus, with this dynamic management, the objective is to reduce losses in times of rising interest rates by maintaining a lower average maturity and to generate capital gains in times of falling interest rates by maintaining a higher average maturity.

Additionally, as we are in the midst of a rate hike cycle with the potential for further increases, investors may want to consider staggering their investments over the next six to 12 months through systematic investment plans (SIPs).

Investing through SIP can help manage volatility effectively, as regular investments over a period of time help spread risk evenly. During a period of rising interest rates, staggering investments help smooth volatility by accumulating higher units. These higher units then help earn higher yields when the interest rate cycle is reversed.

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 hike cycle. Those who invested in a staggered manner during this period and remained invested in the fund for more than three years, say through January 2015, would have earned an extended internal rate of return of 9.2%. The value of your investments would have grown at $3.8 lakh against a cumulative investment of $2.7 lakhs

While tiered investments help spread risk and dynamic duration management helps reduce the impact of changing long-term interest rates, it’s important to understand that this can also lead to increased short-term volatility. Therefore, it is advisable to invest in dynamic bond funds with an investment horizon of at least three years or more.

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

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

So if you understand the risk and can be 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 produce returns is to stay invested and follow the current cycle toward your financial goal.

DP Singh is Deputy General Manager and Chief Commercial Officer of SBI Mutual Fund

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