How Dynamic Bond Funds Change Interest-Rate Risk

The exposure Kabir cannot look up

Kabir checks the duration of every debt fund he holds, because it is the number that tells him how each will behave when rates move. For most of them the answer is stable enough that checking once a year is sufficient.

One of them is a dynamic bond fund, and the number he looked up last year is not the number today. The manager has a mandate to vary it, has exercised that mandate, and Kabir's exposure changed without him deciding anything or being told.

That is not a defect in the product. It is the product. But it means the discipline he applies to everything else — match duration to horizon, and check it — does not work here in the same way.

What "dynamic" means

Most debt funds operate within a defined range of maturity. A liquid fund lends very briefly, a short-duration fund somewhat longer, a gilt fund typically long, and you can look up the duration and know roughly how the fund will behave.

A dynamic bond fund is not constrained that way. The manager may hold long-dated bonds when they expect rates to fall, and move to short-dated ones when they expect rates to rise. The intended benefit is straightforward: capture gains when rates fall and avoid losses when they rise, rather than being locked into one position through an entire cycle.

What Kabir is actually buying

Two things, and they should be assessed separately.

The first is exposure to interest rates, as with any debt fund. The second is a forecast — the fund's duration at any moment reflects the manager's view of where rates are going, so Kabir has hired somebody to make that call repeatedly and his returns depend on whether they are right.

The second is the part worth thinking hardest about. Predicting interest rates is difficult for the same reason predicting equity markets is difficult: the current level of long rates already incorporates the market's collective expectation, so beating it requires being right about something a very large number of well-resourced participants have already considered.

That does not mean it cannot be done. It means the fund is an active bet and should be judged as one, rather than as a category of bond fund.

The risk specific to this category

With a conventional debt fund, the risk Kabir faces is the one he chose when he invested, because duration was known and roughly stable.

With a dynamic fund, the risk changes without him deciding anything. He may have invested when the fund held short paper at low duration; it may now hold long bonds at several times that, and nothing prompted him to notice.

Two practical problems follow. He cannot horizon-match reliably, since the standard discipline — hold duration below the number of years you can wait — depends on knowing the duration, and if it varies he cannot be sure the fund remains appropriate for the money he put in it. And the failure mode is asymmetric with his attention: the fund is most likely to be at high duration when the manager is most confident rates will fall, which is also when the loss is largest if they are wrong.

How to judge one

Past returns are especially misleading in this category, and it is worth being specific about why.

A dynamic fund that held long duration through a period of falling rates will show excellent returns. That tells Kabir the manager was positioned long, and that rates fell. It does not separate skill from having taken more risk in a favourable environment, because the same result would appear from a manager who is simply always long.

Better questions start with what the duration has actually been over time. A fund whose duration has stayed persistently long is a long-duration fund with a flexible mandate rather than a dynamic one, which is a common finding and changes what he owns.

Then, how has it done when rates rose? That is the only test that matters, since a manager who avoided losses in a rising-rate period has demonstrated the thing the fund promises, while one whose record covers only a falling-rate period has not been tested at all.

Has the manager changed? The product is a person's judgement, so if they have left, the record belongs to somebody else. What is the credit quality — dynamic mandates concern duration, but some funds also take credit risk to enhance returns, and two active bets in one product is more than most investors intend to buy. And what does it cost, since an active fund charges more and in an asset class where total returns may be a few per cent the expense ratio consumes a larger share of them than it would in equities. The manager must add more than the fee before Kabir is ahead.

Where it fits

If Kabir wants a dynamic fund, it belongs as an active allocation rather than as the stable part of his portfolio.

Money whose job is safety, or ballast that must hold up when equities fall, should sit somewhere whose behaviour is predictable — which means a fund with a defined and stable duration, matched to his horizon. Money he is willing to have managed actively, accepting that the manager may be wrong, can go into a dynamic mandate, sized accordingly and monitored.

The mistake is putting money into a dynamic fund because the category name sounds prudent, and then discovering during a rate rise that it was carrying long duration all along.

The simpler alternative

Worth stating plainly, because it is the honest comparison.

You can achieve a chosen duration directly by picking a fund whose category defines one and matching it to your horizon. That approach requires no forecast from anybody, costs less, and gives an exposure that does not change without your knowledge.

The case for a dynamic fund is that a skilled manager will do better than that. Whether any particular manager will is the question, and it should be answered with evidence from a rising-rate period rather than from a falling one.

What to take away

A dynamic bond fund varies its duration on a manager's view of rates, which means you own both an interest-rate exposure and a forecast, and the exposure can change substantially without you doing anything.

Judge it on how it behaved when rates rose, on whether its duration has genuinely varied or merely stayed long, on whether the manager is still there, and on cost. Keep it out of the money that must behave predictably — for that, a defined-duration fund matched to your horizon does the job without requiring anybody to be right about the future.