FundsIndia explains: Short-term and Income funds

Short-term and income funds are both versions of debt funds. Both categories derive their returns from accrual, but the instruments they invest in are different and their role in your investments is different. Here is an explanation.

What the accrual strategy is

A debt fund invests in debt instruments. Every debt instrument comes with an interest that it will pay. A fund that holds these instruments earns the interest due or accrued on them. An accrual fund finds corporate or bank debt instruments that pay out the good interest rates based on the quality of the company, options available, and the general interest rate scenario. It then holds these bonds and earns the interest accrued.

An accrual fund does not try to judge the interest rate cycle and gain from price appreciation when rates drop, which is the ambit of dynamic bond funds. Of course, an accrual fund may sell bonds if their prices appreciate since such a sale could give returns a boost. But its primary aim is to identify bonds with the best interest rate for a given level of risk and earn that.

What characterizes an accrual fund

One characteristic of an accrual fund is that its portfolio will hold corporate and bank debt papers consistently. This is because higher accrual or interest is available in such papers and not in government debt. Funds that hold sovereign papers are those that follow duration, because it is primarily sovereign bonds that are the most liquid and reflect interest rate changes in their prices the most.

The second characteristic is that an accrual fund has lower volatility than other categories such as dynamic bond or gilt funds. This comes about due to the strategy of simply accruing interest – this accrual is steady and does not fluctuate much on a daily basis. Second, the prices of the bonds an accrual fund holds do not react to the same extent to demand-supply forces or interest rate changes as sovereign bonds. This is because their lower maturity (compared with gilts) makes them less volatile to rate changes. Third, many of the bonds held may not even be listed for their prices to fluctuate constantly and even if they are listed may be less actively traded compared with gilts.

The third characteristic is that an accrual fund primarily has credit risk and not duration risk. Duration risk is that of interest rate direction turning away from that anticipated by the fund manager. As accrual funds don’t play the rate cycle, duration risk isn’t present. Credit risk is the risk that a debt instrument fails to repay interest or principal. The risk in accrual funds is also that a debt paper it holds has its credit rating lowered – this means that the quality of the company issuing the paper has worsened and the risk of non-repayment of interest and principal moves higher.

Funds following accrual strategy group into three categories. The first is short-term funds, the second is income funds, and the third is credit opportunity funds.

Short-term funds

These funds invest in short-term debt instruments. The average maturity period of their portfolio is rarely over two years. These instruments could be commercial papers, certificate of deposits, corporate bonds, or bank bonds. These funds even pick up long-term bonds which have only 1 -2 years left to mature. For instance, a fund could invest or buy a 5-year bond that was issued in 2013 today, since it has only a year left to maturity. This is why funds often state that the residual maturity – or the number of years left for its bonds to mature – of the portfolio will be a certain number of years.

Short term funds are a good option if you have a 1-2 year timeframe, and you do not need the funds in the near future. Since they invest in higher interest-bearing papers, they deliver returns higher than fixed deposits. While most short-term funds tend to invest only in papers with strong credit ratings, some of them do invest a portion of their portfolio in low-credit instruments to increase returns. Such funds require a higher risk appetite though the horizon required is still 2 years. Else, short-term funds suit all risk profiles.

Income funds

These funds invest in slightly longer term corporate papers when compared to short-term debt funds. This could be 3-5 years. They typically invest in corporate and bank papers, and not in short-term money market instruments. An income fund invests the majority of the portfolio in top-rated instruments rated AAA and above. A fund that puts a significant chunk of its portfolio – half or more – in low credit papers such as AA-rated and below takes on the mantle of a credit opportunity fund.

An income fund suits any investor with a 2-year plus timeframe, but is especially suitable for the conservative and moderate-minded. Like with short-term funds, income funds also deliver returns higher than fixed deposits. On a holding for more than 3 years, capital gains on debt funds are taxed at 20% with indexation benefits (for resident Indians), increasing the income fund’s lead over deposits. Income funds can also be used in long-term portfolios as part of the portfolio’s debt allocation.

We’ll take up credit opportunity funds, another class of income accrual funds, in a separate post. These funds warrant a detailed explanation of strategy and risks.