Introduction
In one of our last posts, we talked about a special category of debt-like mutual funds called Arbitrage Funds. Now, before we understand what is accrual debt mutual funds, let’s take a quick recap of what are debt mutual funds and the types of risks they are exposed to. This will be critical in understanding what accrual funds are.
Debt mutual funds invest primarily in fixed-income generating securities/instruments like Government Bonds (G-Secs), commercial papers, certificates of deposits, and corporate bonds. The issuer agrees to pay a pre-determined interest rate (coupon rate) at specific intervals (monthly, quarterly) during a given time frame.
Types of Risks
While debt mutual funds are a relatively safer option vis-a-vis equity funds, they too are exposed to certain risks:
- Interest Rate Risk: Interest rates set by central banks like the Federal Reserve, RBI, etc. determine the pricing of virtually all productive assets i.e. equity, debt, and real estate. Generally, when interest rates rise, prices of existing fixed-income securities fall and vice versa. For e.g. Let’s say you hold a bond paying a coupon of 6%. Then, interest rates for similar securities rise to 7%. Therefore, to compensate you for holding the bond — the price of that bond will drop in the secondary market to give you an effective return of 7%.
- Credit Risk: All debt instruments are assigned a credit rating from established Credit Rating Agencies like S&P, Moody’s, etc. It usually ranges from AAA (Highest) to D (Default). A credit rating assesses the creditworthiness of the borrower. Or in other words, its willingness and ability to repay the principal amount and interest on time. A fund may assume some credit risk by investing in a lower-rated debt instrument (AA or below) in search of a higher return.
Accrual v/s Duration strategy
Now that we know the types of risks that fixed-income instruments are exposed to, this will give us a better understanding of the two strategies followed by debt funds:
- Accrual Strategy: The accrual strategy is focused on earning interest income from the coupon offered by the securities held in the portfolio. The fund manager typically aims to hold the instruments till maturity. They adopt a buy-and-hold strategy and are suitable for investors who desire to earn stable returns. Although they are not completely immune to the effects of interest rates, the impact is far lower than on duration funds.
- Duration Strategy: The duration strategy involves investing in debt with a view to interest rate movements. The fund manager takes interest rate calls and accordingly either increases/decreases the duration of a portfolio. When the fund is of the view that the interest rate is going to fall, the manager increases his exposure to longer-dated instruments to take advantage of the price increase in bonds (As discussed above, the price of a bond and interest rate is inversely related. When interest rate falls, the price increases).
Which is better?
Again, just like other investing decisions — it is tough to give a point-blank answer that if Accrual Debt Mutual Funds are perfect or not. It depends on a whole host of other factors like your individual risk tolerance, overall portfolio construct, etc. But, at a high level, we can follow the below framework to think about this:
- In a rising interest rate environment: To counter the effect of falling bond prices, one can increase their exposure to an accrual strategy by investing in categories such as Credit Risk funds that follow this style of investing.
- In a falling interest rate environment: To take advantage of an increase in bond prices, one can consider investing in long-duration funds that offer an opportunity for capital appreciation in a falling interest rate regime.
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