FundsIndia explains: Accrual and duration in debt funds

If you read our articles that talk about debt funds, you would find a mention of the terms accrual or duration, or both. These terms are the strategies debt funds follow. While we’ve explained these as parts of other articles, we’ve not had an exclusive one on it yet. This post remedies that!

What is accrual?

A debt fund holds debt instruments, and these instruments pay a particular coupon (interest). The fund, thus, earns the interest on the bonds it holds. So an accrual strategy is simply this – holding a bond, earning the interest due, collect the principal at maturity and reinvest it in fresh bonds. Liquid funds, ultra-short term funds, short-term debt funds, income funds and credit opportunity funds primarily follow an accrual strategy.

What is duration?

A fund following a duration strategy seeks to gain from bond price rallies when interest rates fall. When interest rates fall, bond prices rise – since new bonds will carry a lower interest, existing bonds become more attractive and thus prices rise until yields match the new bonds. A duration fund will try to make capital appreciation from the bonds it holds.

What role does interest rate play?

An accrual fund does not try to time the interest rate cycle. Given the rate scenario and its own mandate, it will look for those instruments that deliver an optimal yield. A duration fund, on the other hand, will estimate the direction interest rates will move and adapt the portfolio to maximise the chances of bond price appreciation.

How do the portfolios differ?

In other words, how do you know if a fund is a duration-based one or an accrual? Duration potential is felt the most in government bonds (sovereign bonds or G-secs or gilts). Gilts are the most liquid debt instruments and also among the few instruments with very long maturity. They tend to therefore reflect rate cuts and rate cut expectations the most. Therefore, a duration fund will load its portfolio with gilts when it anticipates rate cuts. If you see a debt fund holding a large proportion of sovereign bonds, you will know that it is playing duration. These funds will have high average maturities (usually above five years). Plus, as gilts don’t pay high interest, the yield-to-maturity of these portfolios will be low. Remember, investing in gilts is for the capital appreciation they offer and not for the interest component.

An accrual fund will primarily have corporate bonds or NCDs, commercial papers, bank bonds, and certificate of deposits. It will have minimal to no holding in gilts. Depending on the type of accrual fund it is, the average maturity of the portfolio ranges from a few weeks to a few months to a few years. Again, depending on the fund, the yield to maturities will be higher than duration funds. State government bonds (SDLs or state development loans) feature in many debt fund portfolios – these are  for accrual of interest in most cases and not for trading.

Does duration deliver more than accrual or the other way round?

When rates are falling, duration typically delivers more than accrual. Accrual funds too use duration strategy in  a falling rate scenario (as the top-rated corporate bonds they hold can be traded) to push up returns. Bu this is not a primary strategy for them. When interest rates are rising, however, a duration strategy will not work as bond prices will fall. In these times, an accrual fund with higher yields will deliver more. Those with lower yield (like liquid funds) cannot deliver more.

Is one strategy riskier than the other?

Duration funds are inherently more volatile. As bond yields and prices fluctuate on both actual and expected rate action, the NAVs of the funds will also fluctuate. Funds also actively manage the portfolio, upping or dropping the gilt holdings, adding to volatility. Apart from the volatility, the risk is that the fund gets the interest rate call wrong. These funds are generally not meant for holding periods of less than two years. Long-term gilt funds make money only on duration and thus work only in correcting rate cycles. Dynamic bond funds follow duration in falling rate cycles and accrual in rising rate cycles to make the best of both strategies.

Accrual funds have lower volatility. But they aren’t automatically lower risk than duration. Risk in accrual funds comes in when the funds hold debt instruments that are of lower quality or credit rating, called credit risk. Funds take this risk for the higher coupon such papers offer. Rating downgrades hit bond prices and thus NAVs. Defaults by shakier companies, though rare, can cause losses. So when picking an accrual fund, you need to be careful and look at the portfolio. When it takes credit risk, its yield to maturity will be higher.

In some accrual categories, the credit risk is more or less clear. Liquid funds stick to very short-term papers of the highest quality. Income funds are meant for holding periods of over two years and these funds take limited to no credit risk. Credit opportunity funds make it a point to take high credit risk. It gets tricky in short-term and ultra-short term funds as some take credit risk in various degrees and some do not. Looking at portfolio yields will give you a clue – if yields are much higher than others, chances are that the fund has credit risk.

Whom does each strategy suit?

Duration suits investors who can take bouts of volatility in their debt fund returns. Dynamic bond funds are the best since they change their portfolio and strategy as per the rate scenario leaving little to do on your part other than sit tight. Gilt funds need timed entry and exits as duration works only on falling rates and thus suit only informed investors. Accrual suits moderate and conservative investors as they do not have much volatility and are stable. But if you are a conservative investor, remember not to go for credit opportunity funds or funds with high credit risk as they certainly have possibilities of generating losses. These funds suit only very high-risk investors.