Accrual Investment Strategy

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What are accrual funds? How are they different from duration funds?

Accrual funds are debt mutual funds which focus on earning interest income primarily from the coupon offered by securities they hold in their portfolio. On the other hand, duration funds, in focus on generating a significant portion of returns from the capital appreciation that happens when interest rates decline. Accrual funds can also make some returns from capital gains, but these typically tend to be a small portion of their total return. Accrual funds typically have a buy and hold strategy. Instruments bought in the portfolio are held till maturity. Compared to this, duration funds are actively managed depending on the interest rate view of the fund manager.

At a time when debt fund managers feel there is no scope for a rate cut, and there could be an extended pause by the RBI, many of them recommend accrual strategy to fixed income investors.

Why are investment advisors and fund managers recommending investors this category of funds to investors now?

The capital depreciation in a bond portfolio with an accrual strategy is much lower in a rising interest rate environment as compared to duration funds, which could fall fast. Accrual funds are not entirely immune to the effects of rising interest rates, especially when the rise is steep and fast, but the impact is far lower than on duration funds. Many bond fund managers believe that after the 90 basis point rise in yields in the last year, the RBI may be in for an extended pause and there could be volatility in the bond markets. In order to avoid volatility in their portfolios, fund managers are recommending a accrual strategy.

What are the category of accrual funds, which investors can choose from?

There are primarily two types of accrual funds: credit opportunity funds and corporate bond funds. Credit opportunity funds look for mismatches in the current rating of a bond vis-a-vis its fundamentals. When a fund manager believes that the credit rating of a bond could get upgraded due to the improving fundamentals of the underlying company, the bond can see a capital appreciation. Since it also invests in lower-rated papers, such a fund takes more risk than a corporate bond fund. The latter invests in higher quality paper and does not take extra credit risk or look for mismatches between credit rating and underlying fundamentals.

What category of investors should invest?

Investors who do not want volatility in their fixed income portfolios and want stable returns should opt for accrual funds. Being a debt product, these funds enjoy better taxation than plain vanilla bank fixed deposits. Instead of being taxed at 30%, investors in the highest tax bracket get taxed at 20% with indexation benefit on the capital gains in these funds. Investors in the 20% and 30% tax bracket benefit since they get to avail of the indexation benefit.

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