Investors can explore dynamic bond funds

Investors looking at fixed interest rates have witnessed dented returns in the last few quarters and the raging pandemic only further exacerbated their situation. The banking regulator RBI has been reducing interest rates since 2019, accelerated it in 2020 as a response to the tackle the ill-effects of the virus-induced economic contraction. For fixed deposit and other deposit holders, the renewal of their corpus now yield much lower than what they were enjoying earlier, making a dent in their cash flows.

Though, many commentators voice that the central bank is nearer to the end of rate-cut cycle, RBI Governor in a recent keynote address at an industry conclave this week said that the RBI was willing to continue to take both conventional (rate management) and non-conventional (TLTRO, MTM, etc) steps at addressing the unfolding crisis. This puts many fixed income investors in a quandary.

How could they wade through these uncertain times without impacting their plans? Most are also wary of the recent years' debt debacle since the NBFC storm and the subsequent corporate debt defaults which have impacted the debt mutual funds (MF) also.

We know that bond prices and interest rates are inversely related. Every bond issued is nothing, but an instrument declaring the terms of debt and has an interest pay out to the lender - bond holder. The bonds are traded with the price of bond impacted due to the demand-supply equation. The coupon remains constant issued as a percentage of the bond issue price, while yield is the return earned against a bond (at the traded price). The demand for bonds depends upon the prevailing interest rates i.e. at any time a lower-risk bond commands a premium than a higher-risk bond. In a falling rate scenario like the current, the bond prices rise due to demand, bringing the yield i.e. the coupon (interest) earned against the bond.

The panic and the resultant fear aggravated the relatively riskier bonds being traded at a discount, far from their historical levels. This has resulted initially to have long spreads among the AAA (considered as stable) bonds versus the rest of the categories. As the pangs started to settle, investors realized their extreme fears are unfounded and thus the capital began to seep into the other spectrum of the bonds.

Currently most of the short-end of the yield curve has moved down significantly compressing the AAA PSU credit spreads with the other rated bonds, while the long-end of the curve still are at fairly attractive valuations. Opportunity lurks amid this chaos and one need to take a measured risk to gain from this. While uncertainties remain in the short-term interest rates amid rising inflationary environment, there's a likely profit to be made in exploiting this prospect. The long end of the curve includes long tenor corporate and government bonds. While the latter securities have almost negligible risk of default, they're highly sensitive not just to the interest rates, but also to the various government policies, which could have a drawdown on the investment capital. Hence, this is not an all-in strategy and an active management is critical to gain from the gaps.

Dynamic bond funds offer the best of the both worlds by altering the lending duration of their portfolio to utilize the interest rate movements to gain profits. The fund manager by mandate has the option to increase or decrease the composition of gilts (government bonds), which are long-term and other similar profiles in the fund portfolio. In the short run, these funds are subjected to higher volatility and so investors trying to make better of the falling interest rates should consider an asset allocation-based approach within the debt fund allocation. A portfolio of short term for interest (accrual) earning and dynamic funds work out well. Ideally, these decisions are to be done consulting a financial advisor as the past performance of these funds could completely portray wrong expectations of the future.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)