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I had invested ₹4 lakh out of my retirement money in the dividend option of Aditya Birla Dynamic Bond Fund. I invested in January 2017. Please advise whether it is prudent to hold the fund for the long term, say, 2-3 years?

MS Ganesh

If you are a risk-averse retiree looking for regular income, this isn’t a good choice. While Aditya Birla Dynamic Bond Fund has been a top performer in the dynamic bond category, the category itself is suitable only for investors who can take year-to-year volatility in their returns.

As you may know, debt funds outperform their benchmarks by taking on two kinds of active calls — duration calls and credit calls. When interest rates in the economy are falling, debt funds can hold very long-term bonds in their portfolio to gain from rising bond prices. Some funds invest in corporate bonds with lower credit ratings (which therefore carry higher risk of delays or defaults) to earn higher interest.

Now, dynamic bond funds are typically the most actively managed category of debt funds and therefore take on aggressive duration and credit calls. This contributes to high volatility in the returns of these funds.

In the last 10 years, for instance, the annual returns of Aditya Birla Dynamic Bond Fund have varied from a low of 5.5 per cent in 2010 to a high of 14.8 per cent in 2014.

In the last three years, the falling interest rate environment has provided opportunities for dynamic bond funds to amass capital gains from duration calls. But with the RBI in pause mode and market interest rates flattening out, the scope for exceptional gains is limited over the next 1-2 years. If earning steady income is your goal, Aditya Birla Short Term Debt is a better bet.

Investing in the Growth option and setting up a regular cash flow through a Systematic Withdrawal Plan is a better idea than investing in the Dividend option. Dividends paid by debt funds suffer tax at a flat 28.3 per cent at the fund level which cuts into returns earned by investors. The capital gain component in the SWP will be subject to short-term capital gains tax at your slab rate, which may be lower than 28.3 per cent. After three years, gains are taxed at the long-term capital gains tax rate of 20 per cent with indexation benefits.

My family has invested in two debt funds — ICICI Prudential Long Term Plan, Direct and Birla Sun Life Dynamic Bond Fund, Direct. We seek capital appreciation and are long-term investors. Should we continue with the above schemes or switch to some other debt schemes?

Somnath Sanganeria

Since your objective is capital appreciation with relative safety of capital, these funds are reasonable choices.

Both ICICI Pru Long Term Plan and Birla Sun Life Dynamic Bond Fund are debt schemes that dynamically manage the maturity and credit profiles of the bonds in their portfolio, to generate long-term returns for investors. Both funds have made the most of steadily falling interest rates in the last three years, by packing their portfolios with long maturity bonds and thus gaining as these bond prices appreciated sharply.

The steady fall in rates led to exceptional capital gains on these funds in the last three years. However, interest rates in the economy, after falling to 6.5 per cent from 9 per cent plus are showing signs of flattening out as the RBI pauses on rate cuts.

As the room for further declines appears limited, don’t expect a repeat of the past three years’ returns from these funds. The returns on these funds will moderate over the next 1-2 years. These funds being dynamic by nature, you can expect the fund managers to reposition their portfolios in line with such changing market conditions.

Both schemes also have a good long-term track record of navigating different rate cycles. Therefore, if you are a long-term investor, continue to hold on to both.

Send your queries to mf@thehindu.co.in

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