I am a conservative investor with a good amount of exposure in income funds. Now that the yields have touched historic lows, my financial advisor suggests that I buy dynamic bond funds, as this category will provide better returns than income funds. I am not able to understand the rationale behind his suggestion. If both income funds and dynamic bond funds invest in the same universe of securities, how will dynamic bond funds outperform the long-term income funds?
Vanthi Thevan
Your financial advisor is not giving you the right advice, but it is encouraging to know that as an informed investor you are asking the right questions. Your advisor believes that if interest rates stop falling further, dynamic bond funds will do better than income funds. Dynamic bond funds are different from income funds in the way they invest. While an income fund keeps a balance between the proportion of corporate bonds and gilts in its portfolio and the maturity in its portfolio, dynamic bond funds attempt extreme moves. If the fund manager expects the gilt prices to rally sharply vs corporate bonds, he will invest all the money in gilts. If he expects interest rates to rise, he may divert all, or at least a major part of the money into short-maturity instruments, which decline the least when interest rates rise. Take for instance Sundaram Select Debt Dynamic Fund, which started with by predominantly taking exposure in top-rated corporate bonds in September 2002. By April 2003, the fund has exited corporate bonds and has been investing in gilts and money market instruments only.
This is quite unlike a typical long-term bond fund which keeps invested in gilts and corporate bonds in a static proportion. The fund manager may reshuffle the gilt proportion frequently, but there will not be sudden moves. On the other hand, a dynamic bond fund manager will always try to time the market.
Though in the process he may be able to generate higher returns, there is an equally big risk of his call going wrong. Take for instance the volatile period between January 21 to February 14 this year—the average income fund fell 3.19 per cent while the average dynamic bond fund lost 4.30 per cent. Thus, a higher risk-return profile is what differentiates dynamic bond funds from income funds.
This article was originally published on December 18, 2003.
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