By now most of you know the form of risks in debt funds – credit risk and duration risk (and more recently liquidity risk). But when you choose funds, knowing risks alone may not be sufficient. You need to understand debt fund strategies. Just as we discussed both in our portfolio design webinar and through various articles that understanding strategy is important in building your equity portfolio, the same is required with debt as well.
This article will be the first of a two-part basic series – on accrual and duration strategies and which categories of funds follow what.
You will broadly know the following in this article
- What is accrual strategy
- Which categories follow accrual or a hybrid model
- How you can use accrual funds
An accrual strategy aims to primarily earn regular interest income from the investment made and ideally seeks to hold the paper until it matures, other things remaining the same. Funds that use this strategy are also called ‘income’ funds as their primary strategy is to receive regular income from the papers they hold.
An accrual strategy is typically adopted by fund managers in instruments with short to medium term maturity. This is because of three reasons: one, nobody wants to lock into very long-term interest rates unless they are sure it is the highest. Two, locking for the long term, other than in government securities, could spell unforeseen credit risk in future. Three, long term exposes the papers to interest rate vagaries and hence more prone to volatility. They do not thus make for predictable returns.
The key advantages of an accrual strategy are as follows:
- Predictability: As interest income keeps adding to the NAV steadily, there is predictability of returns. For most overnight and liquid funds, if you know the residual maturity (average remaining tenure of the underlying papers) and YTM when you enter, you will get a fair idea of return you can expect over that residual maturity.
- Less volatility: There is less volatility in accrual funds primarily because they are of very short or medium duration. As shorter duration instruments are less sensitive to interest rate moves than longer duration papers, you will see less swings in your fund’s NAV.
Categories with accrual strategy
A very short duration fund and even a medium duration fund can have an accrual strategy. Closed-ended FMPs run on the premise of accrual, getting interest on the instruments till maturity. How do you identify that a fund has accrual strategy? One or more of the following features will dominate in an accrual strategy.
- First, a pure accrual fund will have very low duration. Overnight, liquid, ultra-short, low duration and money market funds will mostly fall here. Please note when we mean average maturity, we mean the overall portfolio’s average maturity. There could be a few papers with longer maturity.
- Second, there won’t be any drastic shifts in the fund’s average maturity if the fund is purely accrual. For example, in categories such as ultra-short or low duration, you will not see the fund upping maturity from 1 to 3 years. They remain rangebound.
- Third, you will predominantly have certificates of deposits, commercial papers and shorter tenure corporate bonds in such portfolios and less of long tenure govt. securities.
- Fourth, if you look at metrics such as standard deviation, you will see that their volatility will be lower than categories that follow duration.
In the table given below, the list from overnight to low duration can broadly be termed as pure accrual. Note that there is no SEBI-stated definition here. We are going by the categories’ characteristics and behaviour in the past.
The categories of floater, short duration and credit risk are also predominantly accrual but with slightly higher sensitivity to interest rate movements. But such sensitivity is kept under check. Floater, for example, uses interest derivatives or uses floater instruments to reduce the impact of interest rate movement. Credit risk category keeps average maturity low and so does short duration.
Before we move to the other categories, here’s a catch. Accrual as a strategy goes behind interest income. Hence, funds can have a mix of quality as well as poor-rated papers with high interest.
As there is no mandate from SEBI on the quality of papers that such funds can hold (other than in few categories such as banking & PSU or corporate bond funds), accrual can expose you to credit risks!
This is the primary reason why picking funds in accrual is challenging. If you didn’t know that a fund had such risks and it is part of your short-term portfolio, then a credit risk event can hit your returns.
Let’s take an example of Kotak Low Duration or Nippon India Ultra Short Duration or ICICI Pru Ultra Short Term. These funds have high returns but hold high exposure to papers below AA+, compared with category average holding. Many of you ask us why we have reservations on such funds on our review tool as they are only short-term funds and are returning well. The reason is that the risk not appropriate to the time frame. Thus, accrual carries such risks that may not be evident. But in categories such as banking & PSU ad corporate bond where SEBI spells the credit risk permitted, it gets easier.
Accrual and duration mix
There are fund categories that general accrual income but also try to earn some extra returns from duration. They do this by taking interest rate calls as well, in a limited fashion. Banking & PSU debt funds, corporate bond funds and medium duration funds all broadly fall in this category.
Even as they try to earn regular interest income, they also try to capitalize on interest rate movements. They play duration within a range, increasing it when they see a rate fall impending or reducing it when they think rates will move up. This way, they try to get the best of both worlds but in a limited way.
It is for this reason that you will see these fund categories showcase more volatility than the pure accrual fund categories we mentioned earlier. How will these funds shift? Let’s take Banking & PSU debt fund as a category. Many of you have only seen PSU and bank bonds in these portfolios. However, in a high rate scenario, these funds reduce their average maturity by not only holding short duration bonds but by also holding simple short tenure bank certificate of deposits. To this extent, they try to reduce the ‘duration’ impact in a high rate scenario (where a rate hike causes price to fall).
This is why, often times, when interest rate direction is unclear, going with this set of funds can help you hedge any wrong calls on duration.
In the table we gave earlier, starting from dynamic bond funds, the strategy is primarily duration. We will explain those in Part II of this article.
Use of accrual strategy
Let us now understand how you can use accrual strategy in your portfolio. We will look at this from the perspective of time frame of your goal, the return you want and from an income generation perspective.
Accrual is good for both short and long-time frames as opposed to duration where you necessarily need a long-time frame (unless you know when to enter).
The data below will tell you pure accrual strategies have lower volatility and will suit both shorter and longer time needs.
With accrual, aligning your time frame closely to the time frame of the fund helps reduce volatility even in medium duration categories. This is why we bucket funds based on times frames in our Prime Funds. If you cannot handle volatility, accrual funds should be the only debt component in your portfolio. They could even be ultra-short funds. The data further below will show you why you won’t suffer much in terms of returns if you stick with accrual (barring credit events).
From a return perspective, barring overnight and liquid which cannot be expected to deliver ‘optimal’ returns, the rest of the accrual categories largely deliver within a range, beating FDs comfortably.
In the data above, you will see that gilt has outperformed accrual in the period that we have considered. This is on account of two factors: one, the rate cycles have become shorter, thus lending themselves to more opportunities for rate-driven rally. Second, the accrual space has been hit by credit over the past 3-4 years, dragging 3- and 5-year returns.
Hence, for longer time frames, if credit remains a big concern (and you can handle shorter volatility) gilts do make for a good choice. This is what we have done in some of our portfolios, irrespective of where we are in the rate cycle now.
Accrual funds make for good options for those looking for income through a systematic withdrawal plan. This is difficult in duration unless you have held, or can hold, such funds for at least 5 years which helps insulate your NAV from wild swings. With very short-term categories (accrual), SWP can be immediate and in other categories it can be started after 1-2 years of holding.