The quiet and calm debt markets—an alternative for the investors; who in India, prefer parking largely in fixed deposits; has turned queasy with returns shrinking as interest rate cycles across the globe and in India are being driven by unprecedented rate hikes as a means to tame spiralling inflation. India’s central bank, RBI too is no exception and has hiked benchmark repo rate by 140 basis points since May 2022.
So, it is no surprise that investors have been caught off guard in terms of the frequency of interest rate hikes. It is widely expected that central bank will continue to remain hawkish for some time even after the inflation peaks out. This has led the Bloomberg Global Aggregate total return index of government and investment grade corporate bonds to correct by about 20% from its 2021 peak. So, how can the investors protect their returns from debt instruments when the interest rates are heading northward? How can they strive to generate reasonable returns in the long-term with better liquidity?
In the current situation, for an investor looking to make a debt investment, the dynamic bond funds category is the best viable option. Here, the fund manager seeks to benefit from interest rate volatility, by managing duration dynamically to maximize return. In effect, the crux of dynamic bond management is duration management. For the uninitiated, duration tells us how long it will take (in years) for an investor to get their principal amount back. For example: A bond with duration of five years means it will take five years for an investor to receive their principal back.
Therefore, if a fund manager is able to tweak duration dynamically based on interest rate scenarios, it will potentially generate reasonable returns in all kinds of market situations. As a result, dynamic bond manager increases duration when the interest rates are expected to fall in order to benefit from the capital appreciation; and reduces duration when interest rates are expected to rise so as to mitigate the risks from the marked-to-market loss. While at it, the fund manager will also strive to maintain a sizable room for margin of safety when the times are tough and macro factors are laden with uncertainties to forecast the interest rate trajectory.
The assessment of interest rate direction also aids in deciding on the share of allocation to government security and corporate bonds. This is a tactical call taken by the fund manager. Given the nature of the category, it is likely that when interest rates are high, a dynamic bond fund will behave like a long duration scheme. Her, the emphasis will be on bringing down the duration to mitigate market loss. While on the other hand, when interest rates are low, the scheme will behave like an accrual scheme, with focus on earning interest income primarily from coupons held till maturity. In this situation, the fund manager will opt for accrual strategy - increase duration to benefit from capital appreciation given the drop in interest rates. A fund manager opts for accrual strategy when the possibility of further rate cut looks low and the central bank is likely to pause policy action.
For an investor looking to invest in a dynamic bond fund, there are various options available. Within these, ICICI Prudential All Seasons Bond Fund is one of the fund that stands out in terms of how it is managed and return consistency relative to its peers. As a means to avoid any potential fund manager bias, the fund relies on an in-house model to take duration calls. When the model parameter indicates a cautious environment, the fund will lower the duration, and vice-versa. As a result, the fund is able to actively manage duration in various interest rate scenarios and thereby deliver consistent performance relative to its peers. The fund over longer timeframes like 3 years, 5 years or 10-years is among the top two performers in the category which is a testament of the robust model driven allocation the fund follows. As an investor, it is imperative that one such invest in a dynamic bond fund with an investment horizon of atleast three years and more to benefit from the investment decisions taken.