Rate cuts, returns and dynamic bond funds

In the first bi-monthly meeting, for the financial year FY20, RBI has decided to cut key policy rates by 25 basis points. Although, some were expecting 50 basis points cut and hence there was even drop in the value of debt funds. This is the second consecutive rate cut by RBI.

The movement in interest rate greatly impacts the debts funds. There is an inverse relationship between the interest rate and the value of bonds. As the interest rate goes down, the value of bonds goes up. Even in debt funds, there are different categories that get impacted differently due to a cut in interest rate. For example, gilt or long duration debt funds are more impacted by movement in the interest rate.

When there is clarity in the movement of the interest rate an investor can take a decision accordingly, however, when there is less clarity on interest rate front it is better to trust the professionals. A dynamic bond fund is one such category, which allows its fund manager to change the portfolio across any instrument and maturities based on his outlook on interest rate movement. That is why dynamic bond funds were considered ideal to navigate uncertainties in the market.

On average, these funds have not generated better returns in the last two calendar years. They have generated a single digit return, however, in the last few months, they have given better returns, which gives hope of better returns, going ahead.

To understand if there is a direct relation between rate cuts and returns given by dynamic bond funds we studied the relation between rate cuts in a year and returns generated by them. We could not determine any relation between them. There were years when there were rate cuts; despite that funds did not give exceptional returns. However, there were years when rates were increased and dynamic bond fund generated double-digit returns. The only thing that we could conclude is cyclicity in the returns generated by dynamic bond funds in the last two years were not great, we can expect better returns in 2019.