Fixed income investors keenly watch interest rate movement in the economy to shift their investments in either short term or long-term debt mutual funds. While short-term debt funds benefit in a high interest rate scenario, long term debt funds generate higher returns in a falling interest rate scenario.

This is because long-term bond prices (net asset values, or NAVs) and interest rates (yields) move in opposite directions. A fall in interest rates will result in a rise in bond prices and positively impact long-term debt and gilt fund NAVs (returns).

Talking about interest rates, RBI has lowered its repo rate by 125 bps (1.25%) to 7.25% between April 2012 and now. Investors who entered long-term debt funds since April 2012 have gained 14% annualized returns until May 31, 2013.

But should investors continue to invest in these funds until the rates bottom out or book profits and invest in funds with more stable returns such as short-term debt funds?

This is the time to look at dynamic bond funds, because — as the name suggests —these funds have the flexibility to adapt to changing market situations.

The increasing popularity of dynamic bond funds can be gauged from the sharp rise in their average assets under management (AUM) from Rs 2,048 crore in March 2011 to Rs 23,113 crore in March 2013 (more than 10 times). They have also provided superior returns when compared with its category benchmark

An analysis of dynamic bond fund portfolios reveals that the average maturity of these funds is dynamically managed vis-à-vis interest rates to maximize their returns. Further, in terms of portfolio quality, dynamic bond funds have maintained optimum credit quality of their debt investments. In the past three years, they invested over 70% of total assets in sovereign and highest rated debt instruments, that is, Gilt, AAA rated and P1+ papers.

It is difficult for retail investors to take a call on interest rate movement and decide on the type of fund to invest in. Dynamic bond funds help address this uncertainty as fund managers take the call and tactically manage interest rate risks for the fund to earn superior returns. However, investors must note that these funds carry the likely risk of a fund manager's call going wrong and result in under-performance.

Hence, checking the track record of the fund house and the fund manager is important while selecting a good fund. A typical investment horizon for these funds is at least three years and is suitable for investors with a moderate risk-return profile. Most funds levy a 1% exit load in case of redemption within one year.

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