Worried About Where Interest Rates Are Headed? Consider A Dynamic Bond Fund…

The Indian economy was already under the spell of a prolonged slowdown when it was hit by the pandemic and the resultant lockdown. Since 2018, India GDP growth has been on a downhill and now it has contracted -23.9% in Q1FY21, the worst in over four decades. The COVID-19 pandemic has been catastrophic to India’s and several nation’s GDP growth.

Even if the economy recovers in the coming quarters, FY21 is likely to end in deep contraction. Several agencies, after a sharp contraction in India’s GDP growth in Q1FY21, have revised downwards the yearly GDP estimates to around -10% from about -5% projected earlier.

The Reserve Bank of India (RBI) as well, in the third bi-monthly Monetary Policy Statement, 2020-21 (dated August 6, 2020) anticipated real GDP growth to remain negative (in line with May resolution) in FY21 owing to the disruption caused by COVID-19.

Only an early containment of the COVID-19 pandemic may impart an upside to the outlook, observed the RBI.

A more protracted spread of the pandemic, deviations from the forecast of a normal monsoon, and global financial market volatility are the key downside risks, it stated.

Graph 1: India’s GDP growth plunged into negative territory due to the COVID-19 lockdown impact


Data as of June 2020 quarter for GDP at constant prices

(Source: tradingeconomics.com)

India’s core sector growth is straying in the negative zone, consumption is muted (the focus currently is on bare essentials and not discretionary spends), inflation is rising, the government is borrowing more, and India’s sovereign credit rating is downgraded to Baa3- with a negative outlook (just a notch above the investment grade).

To address growth concerns (while ensuring that inflation remains within the target), the RBI has been cutting policy rates since February 2019 and maintained its ‘accommodative stance’ since June 2019. The repo rate now stands at a multi-year low of 4.00%.

Table 1: Series of policy rate cuts in 2019-20 to address growth concerns

Month Repo Policy Rate Policy rate cut (Basis points) Monetary Policy Stance
Feb-19 6.25% 25 Neutral
Apr-19 6.00% 25 Neutral
Jun-19 5.75% 25 Accommodative
Aug-19 5.40% 35 Accommodative
Oct-19 5.15% 25 Accommodative
Dec-19 5.15% Status quo Accommodative
Feb-20 5.15% Status quo Accommodative
Mar-20 (an exceptional off cycle meeting) 4.40% 75 Accommodative
May-20 (an exceptional 2nd off cycle meeting) 4.00% 40 Accommodative
Aug-20 4.00% Status quo Accommodative
Total 250

Data as of August 6, 2020
(Source: RBI)

With inflation print moving beyond the RBI’s comfort zone of 4.00% (with a margin of 2 percentage points on either side), over the last couple of months due to supply chain disruptions, the RBI maintained a status quo on the policy rates and maintained its ‘accommodative stance’.

And to ensure that liquidity remains comfortable, the RBI has taken a host of conventional and unconventional measures since February 2020. Cumulatively, these measures have assured liquidity of the order of Rs 9.57 trillion or 4.7% of GDP.

To sail through challenging times, the government too has been front-loading expenditure. But in turn, India’s fiscal deficit has overshot by 103% of the budgeted target (of Rs 7.96 trillion) in the first four months through the fiscal year through July 2020 touching Rs 8.21 trillion.

On the backdrop of the above, the benchmark G-sec yield has hardened. Currently, the difference between the 10-year G-Sec yield and repo rate is around 200 basis points (bps) compared to the long-term average of 80 bps. In general, risk-aversion seems to have set in, which is pushing yields upward.

Graph 2: The 10-year benchmark yield hardening…


Data as of September 8, 2020

(Source: investing.com, PersonalFN Research)

Where are inflation and interest rates headed?

In this regard, the view expressed by RBI Governor, Mr Shaktikanta Das, in the minutes of the last monetary policy is noteworthy:

“As I have been reiterating since October 2019, monetary policy is geared towards supporting the economic recovery process. Although there is headroom for further monetary policy action, at this juncture it is important to keep our arsenal dry and use it judiciously. I also feel that we should wait for some more time for the cumulative 250 basis points reduction in policy rate since February 2019 to seep into the financial system and further reduce interest rates and spreads. Given the uncertain inflation outlook, we have to remain watchful to see that the momentum in inflation does not get entrenched, which is also dependent on effective supply-side measures. As the economy continues to be in a fragile state, recovery in growth assumes primacy. It would be prudent at this stage to wait for a firmer assessment of the outlook for growth and inflation as the staggered opening of the economy progresses, supply bottlenecks ease and the price reporting pattern stabilises. Considering all these aspects, I vote for a pause on the policy rate at this moment while continuing with the accommodative stance” – RBI Governor, Mr Shaktikanta Das

The RBI would remain watchful of incoming data to see how the outlook unravels.

Given these uncertain circumstances, it is difficult to foretell where the interest rates are headed. But overall it appears that the present interest rate cycle has bottomed out.

Why consider investing in a Dynamic Bond Fund?

Regardless of the direction of interest rates in the coming months, dynamic bond funds are capable of taking advantage of a dynamic interest rate and invest accordingly to create an all-season portfolio.

According to the capital market regulator’s categorisation norms, dynamic bond funds are open-ended dynamic debt schemes that invest across duration––short-term, medium-term and long-term––depending on where interest rates are headed. Thus a Dynamic Bond Fund holds the flexibility to adjust the duration of the portfolio to benefit from the possible change in the interest rate scenario.

As you may be aware, bond prices and interest rate are inversely related. In a falling interest rate scenario, long-term instruments tend to perform well; while in the rising interest rate scenario, short-term instruments tend to perform better.

If interest rates are anticipated to escalate, dynamic bond funds allocate a higher portion of their portfolio in low duration bonds and re-invest the proceeds at a higher rate. Conversely, if interest rates are expected to fall, a Dynamic Bond Funds invest in long term bonds to benefit from the subsequent rally in bond prices. Therefore, a Dynamic Bond Fund could typically hold short-term instruments, such as commercial papers (CP) and certificates of deposit (CDs), and/or long-term instruments, such as corporate bonds and gilt securities, depending on the interest rate outlook.

Dynamic bond funds generally invest in fixed income instruments that have a residual maturity of 3 years and above.

Table 2: Report card of dynamic bond funds

Scheme Name ** Absolute (%)** ** CAGR (%)**
6 Months 1 Year 2 Years 3 Years 5 Years
Category average - Dynamic Bond Fund 4.02 8.60 9.82 6.97 8.35

Data as on September 07, 2020

(Source: ACE MF)

At a time when interest on Bank Fixed Deposits (FDs) and other Small Saving Schemes (SSS) have turned unappealing, a worthy Dynamic Bond Fund can help you earn better returns and provide better liquidity.

The investment objective of a Dynamic Bond Fund usually is to generate income and capital appreciation through active management of a portfolio consisting of short-term and long-term debt and money market instruments.

Here are five key benefits of investing in a Dynamic Bond Fund…

  • Reduces interest rate risk through active management of portfolio based on interest rate outlook;
  • No need to time the entry and exit in the debt market because fund managers take care of it;
  • Offers a solution for your long term debt investment needs;
  • Acts as a tax-efficient instrument in the form of indexation benefit on long term capital gain;
  • Potential to earn better returns and have higher liquidity than Bank FDs with higher risk Compare to bank FDs.

That being said, do note that the performance of a Dynamic Bond Fund largely depends on the fund manager’s judgement of the interest rate movement. If the manager fails to accurately gauge the movement of interest rates or is unable to time the investment precisely, investors may suffer losses.

Additionally, the evolving crisis in the corporate bond segment has made debt funds with higher exposure to private issuers vulnerable to credit risk, and may not be considered a safe bet for conservative investors.

Therefore, it is important to invest in a dynamic bond fund with a well-diversified portfolio of securities, a dynamic maturity profile, and high-quality debt & money market instrument (predominantly government securities).

Who should invest in Dynamic Bond Fund?

A Dynamic Bond Fund is sensitive to interest rate changes and may, therefore, witness some volatility. Investors with an investment time horizon of at least 3 to 5 years and who do not mind exposure to some volatility, may consider a Dynamic Bond Fund.

Pay attention to the following parameters to pick the best Dynamic Bond Fund:

The portfolio characteristics of the debt schemes

The average maturity profile

The corpus & expense ratio of the scheme

The rolling returns

The risk ratios

The interest rate cycle

The investment processes & systems at the fund house

On the risk-return spectrum of debt funds, a dynamic bond is placed slightly on the higher-end – between medium duration debt and a long duration debt fund.

Do not assume investments in debt funds (including short-duration funds) to be safe or risk-free; there is an element of risk involved. Therefore, it is important to invest in debt schemes that align with your risk appetite, investment horizon, and investment objective.

Happy Investing!


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Please visit – www.QuantumMF.com to read scheme specific risk factors. Investors in the Scheme(s) are not being offered a guaranteed or assured rate of return and there can be no assurance that the schemes objective will be achieved and the NAV of the scheme(s) may go up and down depending upon the factors and forces affecting securities market. Investment in mutual fund units involves investment risk such as trading volumes, settlement risk, liquidity risk, default risk including possible loss of capital. Past performance of the sponsor / AMC / Mutual Fund does not indicate the future performance of the Scheme(s). Statutory Details: Quantum Mutual Fund (the Fund) has been constituted as a Trust under the Indian Trusts Act, 1882. Sponsor: Quantum Advisors Private Limited. (liability of Sponsor limited to Rs. 1,00,000/-). Trustee: Quantum Trustee Company Private Limited. Investment Manager: Quantum Asset Management Company Private Limited. The Sponsor, Trustee and Investment Manager are incorporated under the Companies Act, 1956.

The data in this presentation are meant for general reading purpose only and are not meant to serve as a professional guide/investment advice for the readers. This presentation has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been suggested or offered based upon the information provided herein, due care has been taken to endeavour that the facts are accurate and reasonable as on date. Quantum AMC shall make modifications and alterations to the performance and related data from time to time as may be required as per SEBI Mutual Fund Regulations. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investment. None of the Sponsors, the Investment Manager, the Trustee, their respective Directors, Employees, Affiliates or Representatives shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the data/information/opinions contained in this presentation. The Quantum AMC shall make modifications and alterations to the performance and related data from time to time as may be required as per SEBI Mutual Fund Regulations.


@Quantum_AMC can you please tell me with raising in interest rate? does return also increase?

Say hypothetically in next 2 quarter RBI interest rate goes 75 bps each quarter. (5.5%) does my return to bonds increase sharply?

With rate increase, your returns in bonds will decrease.

what instruments is best when increase in interest rate is anticipated?

i don’t see 4% is furthermore coming down. it can go up only here onward.

Hi @Pankhushri, Interest rates have an inverse relationship with the price of bonds. When the interest rate starts to move up, the price of existing bonds fall. This in turn pushes down the net asset value (NAV) of debt funds, translating into lower returns for the investor over short period. However, rising interest rate does provide an opportunity to deploy funds at higher yielding bonds and thus over the period returns tend to increase.

The impact of rising interest rates is more on the long duration bonds and thus long term debt funds which are more sensitive to interest rate changes. While shorter maturity funds like liquid funds tend to gain in rising interest rate environment as it get opportunity to rollover maturing short term debt at higher yield debt securities.

From investors’ perspective, a conservative approach would be to invest in liquid funds and short term debt funds. Investors who have longer holding period and higher risk appetite may remain invested in the dynamic bond fund where the fund manager changes the portfolio’s risk profile based on the interest rate environment

I was looking at your fund

Could you please help me understand this.

How come in year 16-17, returns were 16% ? Was it across the category ?
How come in year 17-18, returns were quite low. Was low returns observed across the category ?

What affected the returns so much ?

Very easy to analyze with Money Control website for Mutual Fund Performance, check that year performance. Seems like it was a stellar year for bond funds! @vagar

Thanks Jash. Do you know why those were the largest gainers during that year.

I want to move some money from FD to Debt. Time period is 3-5 yrs. I am trying to ascertain which fund categories would be best.

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2016 was year of demonetization. It was peculiar year as money available with banks increased sharply (since everyone was forced to deposit cash available with them in banks) and hence interest rate dropped sharply too.

As bond prices are inversely affected sharp drop in interest rate resulted in sharp gains in bond funds.
however if your see 2017 and 2018, as interest rates normalize, returns from funds also reduced.

This is how typically bond funds behave, there will be stellar return in 1-2 years, followed by sub par returns in next few (depending on interest rate movement)

Don’t go by any specific year’s return and try to compare it with FD, it will always give wrong impression

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I have personally invested some of my FD money into Bharat Bonds at different time frames.

Indexation benefit is one of the reasons I am investing some portion of my FD into these bonds + I pledge these bonds with my broker for margin for selling options.

@Quantum_AMC I wonder why Quantum Dynamic Bond Fund is underperforming compared to other dynamic bond funds…if fund manager can deliver why are dynamic bonds not giving better returns than other debt funds?

Hi @CoolBird Thank you for your query. Quantum Dynamic Bond Fund invests only in GSEC and PSUs. This portfolio allocation keeps the credit risk at minimal level but it comes with lower interest accrual. Much of the underperformance in QDBF is due to the difference in the credit quality of the portfolio compared to its peers.

Hi @vagar During FY 2016-17, the RBI was cutting rates and there were a lot of liquidity in the banking system due to demonetisation. This led to steep fall in bond yields. During the financial year 2016-17, the 10 year bond yield fell by 79 basis points (1%=100 basis points). This led to sharp jump in bond prices which in turn boost the performance of bond funds which were invested in long term bonds.

Since most of the dynamic bond funds were positioned in long term bonds, most of the funds in that category gained from falling bond yields. Quantum Dynamic Bond Fund returns were slightly higher than the category average during this period.

During FY 2017-18, bond yields moved up sharply due to RBI’s change in policy stance, rising global bond yields and crude oil prices. During the financial year 2017-18, the 10 year bond yield rose by 72 basis points. This led to fall in returns across most of the debt fund categories. Quantum Dynamic Bond Fund returns were slightly higher than the category average during this period as well.

Dynamic Bond funds take high interest rate risk from time to time. So, their short term returns could be highly volatile depending on the interest rate movement. Investors would be better off choosing these funds only for their long term fixed allocation (3 years and above).