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<p>Debt funds are a type of mutual fund whose performance depends on interest rates. When interest rates rise, debt fund returns drop and vice versa. A dynamic fund is a debt fund that benefits from both rising and falling interest rates.</p>

<p>They alternate portfolios between long-term bonds and short-term bonds depending on the underlying interest rate scenario which helps them provide generous returns in fluctuating rate cycles.</p>

<p>As the name suggests, these funds are dynamic in terms of maturity. Generally, debt funds are closed-ended invested in long-term bonds and short-term bonds. Dynamic funds are open-ended investments in both types of bonds. Their main objective is to provide ‘optimal’ returns despite market volatility.</p>

<h2>How does it work?</h2><p>The fund manager of a dynamic firm plays a very important role in managing the portfolio and its performance depends on the manager's ability to predict interest rate movements.</p>

<p>For example, if a fund manager believes the interest rate is about to fall, he/she can increase the fund's tenure. In case he/she believes the interest is going to rise, then short-term bonds are added to the portfolio.</p>

<p>When interest rates are falling, dynamic funds invest in long-term bonds in order to lock in higher interest rates for a long time period. So when interest rates are rising, they invest in short-term bonds with a lock-in of 2-3 years.</p>

<h2>Who Should Invest in Dynamic Bond Funds?</h2><p>The performance of a dynamic fund is only as good as its fund manager’s prediction, hence they are only suited for high-risk appetite investors. Unlike debt funds, which are considered safer, dynamic funds carry high risk.</p><p>Also, investors who want to invest for less than 3 years would look at short-term bond funds. A 3-5 year investment horizon is ideal for a dynamic fund.</p><p>Investors can also invest in a dynamic fund through a SIP (Systematic Investment Plan) approach as it helps combat some volatility. One must always remember that the returns in these funds depend only on the interest rate movement.</p><h2>Risks</h2><p>There are 2 major risks associated with dynamic bond funds. These are - Credit risk and interest rate risk</p><p>Credit Risk: There is a risk that the borrower may not be able to pay the principal and interest amount. This happens when the fund manager invests in riskier bonds with a low credit rating. Which such bonds may have more growth potential, it also has the risk of failing to repay.</p><p>Interest rate risk: Since the whole fund is dependent on the fund manager's prediction of interest rate movement, there is always a chance that he/she may get it wrong. In case the fund manager expects a decline in rates and invests in long-term bonds but the rates rise. /this is an inherent risk any dynamic fund investor has to take. There is a 50-50 chance of winning and losing.</p><p>

<h2>Things to keep in mind before investing</h2><p>1) <strong>Maturity</strong>: Since dynamic bonds invest in both long-term and short-term bonds, the maturity of the funds are varying. They give an average maturity time and an investor must make sure that this average maturity time matches his/ her investment horizon.</p><p>2) <strong>Credit rating</strong>: While it is important for the fund manager to generate good returns, the investor must make sure that the bonds they invest in do not have a low credit rating.</p><p>3) <strong>Expense ratios</strong>: Since dynamic funds are active, they have a higher expense ratio. A high expense ratio reduces your returns, so it is important to compare the expense ratio between funds and make sure it is not too high in comparison to its peers.</p><h2>Taxation of dynamic funds</h2><p>Since dynamic bond funds are debt funds, they follow debt fund taxation. If the holding period of a dynamic bond fund is less than 36 months or 3 years, short-term capital gains tax is applicable. In this, the interest earned is added to your taxable income and taxed as per your IT slab.</p><p>If you hold the funds for over 3 years, a long-term capital gains tax of 20 percent with indexation benefit is incurred.</p><p>Dynamic funds are riskier by debt fund standards but can also deliver higher returns compared to the rest of them. Also, only investors with a horizon of 3-5 years should look to invest in these funds. Before investing in a dynamic fund, it is important to look at its performance for the last 5 years, to understand the capability of its fund manager.</p>

Everything you need to know about dynamic bond funds

Dynamic bond funds are debt funds that can alternate between both long-term and short-term bonds. Let’s understand how it works and key things to keep in mind before investing.

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