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All you wanted to know about...Accrual mutual funds

Dhuraivel Gunasekaran | Updated on June 03, 2019 Published on June 03, 2019

With interest rates in the economy heading down once again, debt mutual fund investors are again wondering if they should switch back from accrual funds to duration funds. However, some categories of accrual funds have been hit by the credit downgrades of the last few months.

What is it?

Fund managers of the debt mutual funds use two types of investment strategies to generate returns. One is called the accrual strategy, wherein the fund manager invests in corporate bonds with higher interest (coupon) and holds on until maturity to earn higher income. Accrual funds looking to maximise their returns usually invest in bonds with lower credit ratings as they carry higher coupon rates.

Some types of accrual mutual funds are liquid funds, ultra-short duration funds, corporate bond funds, credit risk funds and fixed maturity plans (FMPs).

The other strategy is the duration strategy. The fund manager of these funds takes a call on the direction of interest rate movements in the economy and accordingly adjusts the duration of his portfolio to maximise returns.

When interest rates fall, bond prices rise and, vice versa. So when interest rates fall, the fund manager buys bonds with longer maturity.

During periods of rising interest rates, he minimises the duration of the fund to protect against capital losses on the portfolio by buying shorter term bonds. Dynamic bond funds, gilt funds and long duration funds are a few categories that use the duration strategy.

Usually, accrual funds maintain the average maturity of the portfolio in the range of 1-3 years in order to reduce risks from rate swings.

Why is it important?

Accrual funds adopt buy and hold strategies hence their NAVs fluctuate less on a day-to-day basis when compared to that of duration funds. On the other hand, duration funds are inherently more volatile and their NAVs fluctuate more due to interest rate fluctuations as well as fund managers actively churning the portfolio in response to macro changes. However, accrual funds can subject their investors to sudden dips in the NAV too, if credit risk from holding relatively lower rated debt paper manifests. This hunt for higher yield pegs up the risk quotient in these funds. If a company issuing the bond defaults on its dues, the NAV of these funds is written off to that extent, thus impacting the value of the investment.

In recent times, defaults and downgrades of credit rating of debt instruments have impacted many debt funds. The bonds issued by the IL&FS, DHFL and Reliance ADAG Group have all been downgraded sharply.

Why should I care?

Recent events have shown that if you’re earning a high return from a debt fund, it probably carries high risks. Whether the risks come from duration or credit, they tend to crop up when you least expect it. Based on the low volatility in their NAVs, accrual funds were bought by low- to medium-risk profile investors who were looking for bank deposit substitutes. However, the low day-to-day volatility was not really an indicator of the true risks in such funds, as sudden defaults or downgrades in their corporate bonds have now led to sudden NAV write-offs and losses to investors.

Rather than switching frequently between accrual and duration strategies, you should be sticking with the strategy that best meets your needs. If you need regular income, stay with accrual funds. You can always minimise the risk in accrual funds by looking for those with moderate returns and AAA-rated portfolios.

The bottomline

Don’t confuse mutual funds with bank deposits, even if they look and feel like them.

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Published on June 03, 2019
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