Dynamic Bond Funds — Paying Somebody to Call Interest Rates

A bond price moves when interest rates change, and how far it moves depends on how long the bond has left to run. Our page on gilt funds explains the mechanism.

Most debt categories pin that length to a range, which is why our page on short duration funds describes them as rungs on a ladder. The investor chooses a rung that matches their horizon, and the scheme stays roughly there.

A dynamic scheme removes the pin. If the manager expects rates to fall, lengthening the portfolio means bond prices rise more when that happens. If the manager expects rates to rise, shortening it limits the damage. The scheme is designed to move between rungs rather than to sit on one.

An interest rate view, held on your behalf, and it is worth being plain about that.

When the manager positions correctly ahead of a change in rates, the scheme can do noticeably better than a fixed-duration scheme would have. When the manager positions incorrectly, it can do noticeably worse, and the size of both outcomes is larger than people expect from something described as a debt fund.

It is also worth noticing that the manager is making this call for everybody in the scheme at once, including investors with very different horizons. A position that suits somebody holding for five years may be uncomfortable for somebody holding for eighteen months, and the scheme cannot distinguish between them.

Forecasting the direction and timing of interest rates is difficult, and professionals disagree about it constantly. That does not make the category unreasonable. It means the outcome rests on a skill that is genuinely hard, and our page on active versus passive funds covers the same trade-off in equity.

Past performance in this category depends heavily on which rate environment the period covered.

A stretch of falling rates flatters schemes that held long paper, and a stretch of rising rates punishes them. So a strong record over three years may reflect a manager good at reading rates, or a period in which long positioning happened to work, and the figure alone cannot tell you which.

What is more informative is how the scheme duration actually changed over time, and whether those changes preceded rate moves or followed them. That is visible in historical fact sheets, which our page on the fact sheet describes, and our page on how returns are calculated covers why a chosen window flatters.

The dynamic label refers to duration only. It says nothing about who the scheme lends to.

Some schemes in the category stay largely in government and top-rated paper, so the only real variable is duration. Others hold a share of lower-rated debt as well, which adds a credit risk that can arrive suddenly, as our page on credit risk funds explains.

So reading a dynamic scheme means checking two things rather than one: how long the holdings run at present, and who the borrowers are. A scheme taking both a large duration position and a credit position is carrying two separate bets at once.

The natural alternative is to choose a debt category whose holding period matches your horizon and let it sit there.

That approach gives up the possibility of benefiting from a well-timed rate call, and in return it removes the possibility of suffering from a badly timed one. The behaviour becomes predictable, which is usually what somebody wants from the stable side of a portfolio.

A banking and PSU scheme or a target maturity scheme are examples of debt holdings where you know roughly how the scheme will behave when rates move. A dynamic scheme gives you a manager deciding that for you instead.

A narrow group, in our experience.

Somebody with a horizon of several years who understands that the value can move meaningfully in both directions, who holds this as part rather than all of the stable side, and who is comfortable delegating a rate view rather than choosing a fixed holding period.

It is not a place for the buffer, for money needed within a couple of years, or for anybody who chose debt precisely because they wanted to stop thinking about market movements. For those, a fixed rung matched to the horizon is the simpler and more honest arrangement, and our page on asset allocation sets out how to match them.

Four questions, in order.

• Do you want a rate view held for you at all, or would a fixed holding period suit you better?
• What is the current duration, and how far has it moved over the past few years?
• What is the credit quality, and is the scheme taking a credit position alongside the duration one?
• Is your horizon long enough that a wrong call has time to be recovered?

We are distributors rather than investment advisers, we recommend no schemes, and we offer no views on where interest rates are heading. If you want help reading what your debt holdings are actually doing, get in touch.