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Concepts & Tutorials

Dynamic Bond Funds

I’ve had two questions on email recently about Dynamic Bond Funds.

The concept of Dynamic Bond Funds needs an understanding that bonds are complicated, way more than stocks. A few things that make bonds different:

a) Issuer creditworthiness: Is a government bond more likely to default, or a second rate corporate bond? Would a Reliance bond have a chance of default more than say an ICICI Bank bond? The lower the credibility the higher the interest rate one asks for.

b) Yield: How much interest will I get, on a comparative basis, for this bond versus that one?

c) Time to maturity: A lesser time to maturity usually means a lower interest rate, since the haziness about whether an issuer is creditworthy (or will not default) is lower in the short term.

d) Smaller things like “is this bond secured against the company’s assets?”, “is this bond liquid?” etc.

Dynamic bond funds are essentially those that vary the above based on the fund manager’s discretion. Usually the fund manager will go into shorter term securities in a rising interest rate cycle, or move from corporate to government bonds at a time when the economy is slowing, and so on.

Now to the questions:

What’s the difference between a Gilt Mutual Fund and Dynamic bond funds?

A Gilt fund invests in Government securities only. Within Gilt funds you have further classifications: “short term” gilt funds that invest in T-Bills (<365 days) or in 1 to 3 year govt securities. Or “long term gilt funds” that hit the higher terms.

Dynamic bond funds are supersets; they can choose to invest in gilts or in corporate bonds or commercial paper, or all of the above.

Second Q:

I typically purchase funds with valueresearch rating of 4 or 5. Hence, I have selected and started investment (redirecting new investments for fixed income and proceeds from redemption of ultra-short schemes) in L&T Flexi Debt fund – Growth (VR 5 star fund). Now I am looking at diversifying by investing in another fund of similar philosophy. I was evaluating Birla Sun Dynamic Bond, SBI Dynamic Bond, BNP Paribas Dynamic Bond (erstwhile Fortis Flexi Debt), Kotak Flexi-Debt (which is surprisingly classified in ultra-short term in VR, I think due to maturity of currently held portfolio) but could not reach a conclusion.

Can you please suggest approach for identifying such a fund? Also, can you please suggest some good ones (from them or apart from these)?

Now I don’t invest in dynamic bond funds, but I would use the following rules:

– The fund has to be at least five years old, or you should really trust the fund manager.

– Check the performance in a rising interest rate cycle, and a dropping one. For the record, here if the interest rate history in India:

image

– Here’s where you really need time and effort: During the periods of falling rates, you will need to go back, download the fund’s disclosure statement and see if the average maturity of their portfolio went UP or DOWN, and whether you liked their move into/out of government bonds.

– Check relative performance with other fund categories (like gilt funds, income funds or other such).

– Make sure exit loads aren’t onerous.

– Lastly, understand that the product carries risk. Bonds are not risk free.

If you can’t do the analysis, get your advisor to provide you with it. (And pay him; tell him you’ll buy the product online) If you can’t do that also, don’t buy the product. A fixed deposit at a bank also works.

Dynamic bond funds basically are like that Indian Software company that says, “Boss we do Windows, Java, Web, C++, Linux, Android, iPhone and Nokia coding, any language, any platform, anything”. There are very few companies that have successfully done all of them, so you have to analyse past performance and be able to trust the fund manager.

While I’d like to analyse the funds, I think it’s better if I let each interested person do it himself – the exercise itself provides the learning. Also because I can’t afford the time, but that’s a different matter!

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  • “Boss we do Windows, Java, Web, C++, Linux, Android, iPhone and Nokia coding, any language, any platform, anything”.
    Priceless comment! too good!!
    On a separate note, I have so many unanswered questions regarding debt-funds. I have decided to go for SBI fixed deposit till I figure out satisfactory answers for my pending debt-fund questions.

  • Anon says:

    I write as a former fund manager and senior executive of the fund industry, who’s actually managed fixed income portfolios for more than a decade. Prefer to remain anon though.
    All I have to say is – Articles like these unnecessarily tarnish the image of mutual funds and mutual fund managers without any justification.
    Dynamic bond funds are just plays on the interest rate cycle. The only thing that is true in the article is that fund managers anticipate interest rate cycles and alter their portfolio “duration” (you have used a surrogate – average maturity – which will do for a basic understanding) accordingly. If their anticipation turns out right, they do well, else they don’t. There are times that fund managers views have turned out to be right and they have been feted for it. On other occasions they’ve been hauled over the coals since they didnt anticipate correctly. It’s all part of the game.
    Your analogy to software companies trying to do everything at the same time is therefore thoroughly misplaced and i wish readers realise that. Dynamic bond funds attempt to vary only interest rate risk. There are other types of funds which attempt to take advantage of other things like credit risk etc. but that’s a separate discussion.
    Also, the relevant interest rate is “market interest rate”. You have displayed a chart of the policy “repo” rate as a surrogate for interest rates. On most occasions, you’ll find market interest rates do not necessarily follow the policy rate. If at all, they probably lead the policy rate more than they follow. As an expert you’ll know that this is true for almost all market behaviour.
    The correct variable to use for depicting interest rates is therefore the yield on benchmark bonds (either the 10 year or the 5 year Government bond benchmark or a suitable Corporate Bond benchmark). This is precisely the reason benchmarks are there for.
    As for people seeking advice on which dynamic bond fund to invest, all I’d say is go by the track record and style of the fund manager. If you like his / her track record and style stick by him/her. The only other variable to consider is – does the fund size provide enough leeway to the fund manager to move in and out of securities efficiently and quickly. Granted it is very difficult to judge this. Everything else (including your so called 5 year track record suggestion) can be safely ignored.

    • To clarify, I re-read and realized that I seemed unnecessarily harsh on fund managers. This was totally unintentional, I had no intention of belittling them. In fact, I have no intention of belittling the shop that does everything. after all, that includes the likes of Infosys, TCS, Satyam and Wipro. These are good business that, quite literally, do everything in the development areas I have mentioned. There are also small shops that do the same thing, and you never know when they might grow into the next Infosys. The fact that you do everything does not mean that you are bad – a dynamic bond fund manager has the ability and the mandate to invest wherever he/she likes, and you want that rockstar you can trust to make the right decisions. When you give someone a lot of power, you must be sure they are up to the act. That was my suggestion. (This applies to hedge fund managers as well, who typically invest in anything and everything)
      Second, since bonds involve so many things, the point about dynamic bond funds is that it allows investment in multiple kinds of bonds. Typically, like you said, the main objective is to predict interest rates. But, unlike gilt funds, there is no presumption of security (like a GOI sovereign guarantee) that bond managers need to stick to. So if they choose to invest in a corp bond because they think it will respond the best to a loosening cycle that’s one way to look at it, but from the investor’s point of view that introduces a level of credit risk he might not have thought about; the point is that you have to trust your fund manager, and base your decisions on his track record/performance.
      Third: I showed the repo rate and I realize what you mean, that it’s not the market rate in many cases. In fact I’ve posted a number of times about the current situation of an inverted yield curve in goi securities and in CP vs. corp bonds. You could use a benchmark rate like a 1 yr t-bill or a 10 yr bond (in this case, the 10 yr rate needs to be changed from a semi annual rate to an annualized rate for hte sake of comparison across different types of issuers). Getting this data is difficult but definitely possible. Then you shouldn’t care what each fund uses as their benchmark – simply check how performance has been in an upcycle in your benchmark, and/or how the portfolio wted avg maturity changed.
      The problem still is that we have had too few interest rate cycles within which mutual funds have existed – about four in total, probably, and we haven’t had a systemic crisis that involves people going bust (yet). So all back-testing has this fat-tail problem that we know that the shit will hit the fan once every decade, and it’s been more than a decade since it last really did. Many of these funds (or fund managers) don’t even have that performance during the shit-hits-the-fan time. On top of the analysis, it’s going to be a little faith and luck.
      Finally, you’re right that it’s about the fund manager, not the fund. (Certain fund houses though have a process based investment where the fund manager’s input gets diluted) I wrongly assumed that the fund should be 5-years old – the fund manager should have a five year track record. Fund size is an interesting angle as well, I suppose it would be useless to have funds with less than 50 cr.-100 cr. since each trade is 5cr. But is there a minimum you would recommend?

  • Anon says:

    Deepak,
    Thanks for your detailed response.
    Just a few points I’d like to point out.
    Agree that there have largely been very few interest rate cycles. After all interest rate deregulation only began after the BoP crisis of 1991.
    But you ignore the fact that the market is much more dynamic with lots and lots of ups and downs (even intra day) within these broad cycles.
    Much like the stock market to which you can probably relate better. Havent we had just a few bull and bear market cycles? But then traders like yourself take advantage of the up and down moves within these cycles too.
    That’s what a dynamic bond fund tries to capture. Call it day trading, speculation whatever. It still has it’s economic benefits.
    You’re mistaken in assuming that dynamic bond funds are mostly passive and try to take advantage of only long term interest rate cycles. On the contrary a well managed dynamic bond fund actually trades in and out very frequently (don’t worry – trading costs are negligible).
    The travesty of most dynamic bond funds that we have currently is that they actually trade very little – I wouldn’t like to get into the reasons why!
    On fund size – it depends on the portfolio actually. If the portfolio is built using liquid, regularly traded government securities for which prices are regularly quoted, size doesn’t matter. The fund manager can churn the portfolio efficiently even if fund size is small (5 crores is bare minimum of course). However, if the portfolio consists of a mix of government bonds and corporate debt, a larger fund size – say 50 crores plus is desirable. Too large a portfolio (250 crores plus) actually makes it difficult to manage dynamically (unless there is a dedicated fund manage – In India one fund manager manages several funds and that makes his / her attention span even smaller).
    The cause and effect is actually reversed – If I were a fund manager I would tailor my investment style and portfolio to the size. I dont expect “size” to tailor itself to what I may think is the correct style. Much like moving the sail to favor the wind and not the other way round.
    The difficulty for investors and analysts is how to analyse debt fund portfolios properly. One of the most important parameters is portfolio liquidity (not cash as a surrogate of liquidity but how quickly and efficiently can the portfolio be converted to cash). This is almost impossible for laypersons to analyse even with all the available information.
    Maybe one day I’ll do that! 🙂
    As for your observations that most Indian debt fund managers havent seen “shit hitting the fan”. Broadly I agree, but frankly October 2008 was one such period. Many fund managers actually witnessed shit hitting the fan.

    • Thanks very much!
      I know what you mean when it comes to stocks, but we have seen the edge of the abyss in stocks, and the swings have been very wild (we have seen four different days in which the stock index has made moves of over 10%, many stocks have fallen 80% in one day and so on). Cycle wise stocks have seen maybe two or three more cycles than bonds in the same time period. (If I assume that a 30% fall from a peak is a down cycle, and a 30% return from a bottom is an upcycle)
      Not to say that 2008 wasn’t bad, but it was short and kept sweet and we managed to save everyone, which is perhaps strange because we were quite levered then as well.
      I’d love to hear you talk about why bond funds trade little – if I promise to keep it anonymous, would you like to guest-post it here? (deepakshenoy@gmail.com) Thanks in advance.
      Thanks for your inputs on the fund size; it’s interesting that in India, even 250 cr. can be difficult to manage. I see the CCIL volumes and quotes on the NDS and on BRICS but didn’t realiize the market wasn’t too well geared for regular trading. Also, your point about cause and effect is well taken – if you get more money, you might as well adjust your investment style to filter out strategies that will not allow you to trade size. That’s similar to stocks – as a fund gets bigger and bigger, it will have to eliminate small caps, and sometimes more midcaps. Plus, trading frequency must reduce – some of these stocks trade less than a crore a day.
      Yes, liquidity in terms of convertibilty (or even “transferability” into another kind of portfolio) is darn difficult because things can change overnight, certain bonds can lose liquidity etc. You definiteily should wriet about how to analyze debt fund portfolios; and in fact, I would love to speak with you about creating a more detailed bond information portal too!
      Again, thanks for your inputs, and I hope we hear from you. As always, my word is far less important than that of a person who actually has managed money, like you, so if there’s any errors or omissions, they’re all mine 🙂

  • Anon says:

    Thanks, Deepak for the offer.
    I think there’s much more to discuss, than just guest posts.
    Please await my call – sometime next week. Won’t be able to do so before that.
    And don’t worry – though we dont know each other – I have your phone number 🙂
    Cheers

  • Ashish says:

    Hello Deepak,
    I must thank you for this great post and should thank you and Mr Anonymous for even greater level of discussion in comments.
    Ashish

    • Thanks Ashish, and I think Mr. Anonymous deserves all the credit! Another round of thanks from me – answers (and also creates) questions around the whole lack of awareness among investors about bond trading concepts and how funds work….