There are various catagories of debt funds available for investors, such as: short-term income funds, credit opportunities funds, corporate bond funds, income funds, gilt funds and dynamic bond funds.
While some of these clearly have a higher risk threshold, which makes them unsuitable for your stable-return allocation, investors do have the choice of looking at short-term income funds or dynamic bond funds for their short to medium term allocation.
If you focus just on the returns, which may not always be a smart thing to do, then dynamic funds score over short-term bond funds. As dynamic funds can invest in longer-term securities, they outperform short-term funds on many occasions. Short-term income funds invest in bonds with a maturity of 1-3 years and currently give 9-10% annualized returns. Dynamic bond fund returns have historically shown a wider range and for the past 1 year, returns have ranged between 7% and 13%.
Interest rate risk
Short-term income funds are designed to generate income from interest on short to medium term bonds. This accumulated interest, referred to as accrual income, adds up in the net asset value. Steady income makes returns less volatile. Dynamic bond funds are not restricted to any type of investment or security. They can earn accrual income or capital gains from an active duration strategy. But this type of strategy adds to interest rate risk. Funds with high duration can have volatile returns in the short term.
Short-term funds don’t invest in very long maturity bonds since they try to deliver steady returns in the 1-3 year period. Dynamic bond funds try to take advantage of any interest rate or corporate bond opportunity. They can have portfolios of very short maturity securities or very long maturity securities or a mix. For stable returns in a 1-3 year period, it makes sense to match your investment timeline with the fund’s average maturity. Unless you are market savvy, it’s difficult to do this with a dynamic bond fund.
In short-term income funds aim for steady returns. A portion of the portfolio may take more timely positions in bonds but that allocation would not be significant. In dynamic bonds, fund managers actively manage the interest rate risk by buying and selling long-maturity securities several times. Hence, you have to rely on the manager’s ability to identify high-quality bonds and also on her ability to visualise the interest rate trend accurately. Thus, the risk of active management is higher in dynamic funds.