Debt funds apply 2 strategies to assure higher returns. They are duration strategy and accrual strategy. But both strategies have a vast difference between them. The accrual vs duration funds is all we going to discuss in this blog. Lets first understand what are these funds and what are their strategies.
This mutual fund intends to invest in companies that have a least credit rating but are well-managed. The plan here is to purchase those companies where the fund manager demands credit ratings to develop, which will feasibly lead its price to go up and profit the fund. This strategy is called accrual strategy.
- Accrual Funds ideally centre to receive interest income in terms of coupon offered by Bonds.
- These funds typically invest in short to medium maturity papers which are of mid-to-high quality while concentrating on holding securities until the maturity.
- Accrual Funds can earn returns from the capital gains, but this performs to be a small portion of their total returns. Usually, the funds which follow accrual strategy purchase short-term instruments and favour to keep till maturity. This is because it serves to decrease the interest rate risk.
- Accrual funds are an excellent investment option for investors who have a perspective about the interest rate movements.
- Ultra short term bond Funds, FMPs, and Short Term Bond Funds serve this strategy.
- These funds take a credit-risk and spend in somewhat lower-rated securities, to produce higher yields.
If an investor requires a constant return from his debt portfolio and is not willing to take higher risks, must invest in Accrual based funds. But, an investor must have a look at interest rate movements. It is recommended to invest in Accrual Funds for least a 1-3-year horizon.
- The funds which serve the Duration based strategy invest in long-term bonds and profit from the interest rates fall.
- They profit from capital appreciation onward with the coupon of the bond.
- However, these funds are opened to interest rate risk and these funds can bear capital losses if the interest rates go higher.
- Fund managers centre is extremely on controlling the duration to maximize returns because he/she predicts the interest rate movements. The wrong assumption can make duration based debt funds bear losses.
- Usually, when the interest rates go down, the fund manager picks an almost high duration to maximize capital gains from the growing bond prices.
- In Vice-versa situation the interest rates are increasing the duration of the fund will be reduced, just to safeguard against capital loses on the portfolio.
- Long-Term Income Funds and Gilt Funds serve the duration based strategy.
Hence, these funds are fit for investors who can take with the volatility linked with the fund. These funds can produce a higher return in a time when the interest rates are set to go downwards.
What role does interest rate play in Accrual Fund Vs Duration Funds?
A duration fund will determine the way interest rates will move and modify the portfolio to maximise the possibilities of bond price recognition. An accrual fund does not have time to try the interest rate cycle. Given the rate scenario and its mandate, it will watch for those instruments that provide an optimal yield.
How do the portfolios differ of Accrual Fund Vs Duration Funds?
- Duration potential is considered the greatest in government bonds. Gilts are the common liquid debt instruments and also with the few instruments with a very extended maturity. They tend to reveal rate cuts and rate cut expectations the most. Hence, a duration fund will fill its portfolio with gilts when it expects rate cuts. If you see a debt fund keeping a high proportion of sovereign bonds, you will recognise that it is working duration. These funds will have a long average maturity normally more than 5 years. Plus, as gilts don’t pay huge interest, the yield-to-maturity of these portfolios. Identify, investing in gilts is for the capital appreciation they offer and not for the interesting part.
- An accrual fund will essentially have corporate bonds or NCDs, commercial papers, bank bonds, and COD. It will have minimum to no holding in gilts. Depending on the type of accrual fund it is, the average maturity of the portfolio differs from a few weeks to a few months or a few years. Again, depending on the fund, the yield to maturities will be more than duration funds. State government bonds emphasise in various debt fund portfolios – these are for accrual of interest in most cases and not for trading.
Do duration funds deliver more than accrual funds?
When rates are dropping, duration typically delivers higher than accrual. Accrual funds too apply duration strategy in a decreasing rate scenario to push returns upwards. But this is not a primary strategy for them. When interest rates are increasing, though, a duration strategy will not work as bond prices will drop. In these times, an accrual fund with higher yields will give more. Those with weaker yield like liquid funds cannot deliver more. So the situation this cannot be said that which provides best returns. It all up to marketplace drop and rise.
Which one is riskier –Accrual Fund Vs Duration Funds?
- Duration funds are naturally more volatile.
- As bond yields and rates vary on both actual and expected rate action, the NAV of the funds will also vary.
- Funds also actively handle the portfolio, rising or dropping the gilt holdings, computing to volatility.
- Apart from the volatility, the risk is that the fund receives the interest rate appeal reverse.
- These funds are usually not meant for holding periods of less than 2 years.
- Long-term gilt funds make money just on the duration and thus work only in improving rate cycles.
- Accrual funds have less volatility. But they aren’t automatically less risk than duration.
- Risk in accrual funds comes in when the funds keep debt instruments that are of less quality or credit rating, called credit risk.
- Funds take this risk for the greater coupon such papers offer. Rating declines hit bond prices and thus NAVs can cause losses. So when choosing an accrual fund, you require to be careful and view the portfolio.
- When it takes credit risk, its yield to maturity will be more high-priced.
Whom does each strategy suit?
Duration suits investors who can take sessions of volatility in their debt fund returns. Dynamic bond funds are the most suitable since they develop their portfolio and strategy as per the rate scenario. Gilt funds need timed entry and exits as duration works only on lowering rates and thus satisfy only informed investors.
Accrual suits moderate and stable investors as they do not have much volatility and are durable. But if you are a moderate investor, remember not to go for credit opportunity funds or funds with large credit risk as they surely have chances of forming losses. These funds only fit for high-risk investors.
Points of Differentiation- Accrual vs Duration funds
Interest rate risk
Duration debt funds take a note on the interest rate situation and place their portfolios respectively. If they determine interest rates to decline, they purchase longer-dated bonds. If their calls go right, they are profited highly. But if their calls go wrong, they get huge losses. Accrual strategy funds don’t normally take interest rate risk, they hold to short- and medium-tenured bonds.
Accrual funds take on credit risk by purchasing companies that have a low credit rating but robust fundamentals. The strategy behind this is if the company is balanced as they think it is, its credit rating is bound to develop at any point. This uptick in credit rating will push up its cost and the fund profits. But if the company experiences a downgrade in rating, the fund can suffer loss severely.
Many distributors suggest fixed-income funds as a choice to bank fixed deposits. Even recommend moving a part of the FD corpus to debt funds. Here, accrual funds work as they invest in companies for the long-term and intend to capitalise on the rate of interest income. Duration funds are never proposed for regular income. They typically manage to capitalise for a shorter time.
Accrual Funds have a huge risk as a fund manager who went wrong on her duration call can improve relatively quickly from his wrong decision. Errors and downgrades of companies can be devastating, as it not only points to declines but spreads panic that ends in large outflows. Accrual funds, hence, may be bought as a topping and not part of your core portfolio.
How to Decide which is best?
Since each of them carries its risk factor, an investor can also choose a blend of both the type of funds in his debt portfolio according to their risk profile. An accrual strategy fund, if proceeded too aggressively, may point to an expansion in credit risk in the portfolio. The duration strategy can handle an interest rate risk or a risk of volatility if the appeal of interest rate movements of the fund manager proceeds wrong. Hence, both the strategies have their benefits and have a varied risk-reward plan for the investor.
The suitability of a precise fund is based on the risk appetite and goals of the clients. The following is a checklist of the key traits of the particular strategy based funds:
- More volatility in NAVs’ for duration based funds than accrual-based funds
- Accrual fund strategy is relatively more expected in returns and can be a selection for the conservative investor.
- Accrual fund strategies are more durable in the sense that they continue for long periods and require not to be evaluated during various cycles of interest rate fluctuations.
- Duration based funds are only valid when interest rates decrease and require close monitoring.
- Fund managers often set the risks of duration based bonds by proposing dynamic bond strategies where a shift in portfolio mix is advised based on the changes in the interest rate.
Accrual and duration funds serve their goal for diverse purposes and plans. But, for a first-time investor, duration funds would be a safer play. Now, the difference is clear of accrual vs duration funds and its easy to simplify which fund suits to investor according to his needs and requirements.
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