Debt Mutual Funds: Duration Funds vs Accrual Funds

A debt fund holds debt instruments, and these instruments pay a particular coupon (interest). An accrual strategy is holding a bond, earning the interest due, collect the principal at maturity and reinvest it in fresh bonds. Liquid funds, ultra-short term funds, short-term debt funds, income funds and credit opportunity funds primarily follow an accrual strategy.

A fund following a duration strategy seeks to gain from bond price rallies when interest rates fall. When interest rates fall, bond prices rise – since new bonds will carry a lower interest, existing bonds become more attractive and thus prices rise until yields match the new bonds. A duration fund will try to make capital appreciation from the bonds it holds.

An accrual fund does not try to time the interest rate cycle. Given the rate scenario and its own mandate, it will look for those instruments that deliver an optimal yield. A duration fund, on the other hand, will estimate the direction interest rates will move and adapt the portfolio to maximize the chances of bond price appreciation.

Duration potential is felt the most in government bonds (sovereign bonds or G-secs or gilts). Gilts are the most liquid debt instruments and also among the few instruments with very long maturity (10-20 years). They tend to therefore reflect rate cuts and rate cut expectations the most. Therefore, a duration fund will load its portfolio with gilts when it anticipates rate cuts. If you see a debt fund holding a large proportion of sovereign bonds, you will know that it is playing duration. These funds will have high average maturities (usually above five years). As gilts don’t pay high interest, the yield-to-maturity of these portfolios will be low. Investing in gilts is for the capital appreciation they offer and not for the interest component.

An accrual fund will primarily have corporate bonds or NCDs, commercial papers, bank bonds and certificate of deposits. It will have minimal to no holding in gilts. Depending on the type of accrual fund it is the average maturity of the portfolio ranges from a few weeks to a few months to a few years. Depending on the fund, the yield to maturities will be higher than duration funds.

When rates are falling duration funds delivers more than accrual. Accrual funds too use duration strategy in a falling rate scenario (as the top-rated corporate bonds they hold can be traded) to push up returns.

Duration funds are inherently more volatile. As bond yields and prices fluctuate on both actual and expected rate action, the NAVs of the funds will also fluctuate. Funds also actively manage the portfolio, upping or dropping the gilt holdings, adding to volatility. Apart from the volatility, the risk is that the fund gets the interest rate call wrong. These funds are generally meant for holding periods of more than two years.

Accrual funds have lower volatility. But they aren’t automatically lower risk than duration. Risk in accrual funds comes in when the funds hold debt instruments that are of lower quality or credit rating, called credit risk. Funds take this risk for the higher coupon such papers offer. Rating downgrades hit bond prices and thus NAVs. Defaults by shakier companies, though rare, can cause losses. So when picking an accrual fund, you need to be careful and look at the portfolio.

In some accrual categories, the credit risk is more or less clear. Liquid funds stick to very short-term papers of the highest quality. Income funds are meant for holding periods of over two years and these funds take limited to no credit risk. Credit opportunity funds make it a point to take high credit risk. It gets tricky in short-term and ultra-short term funds as some take credit risk in various degrees and some do not.

Duration suits investors who can take bouts of volatility in their debt fund returns. Dynamic bond funds are the best since they change their portfolio and strategy as per the rate scenario leaving little to do on your part other than sit tight. Gilt funds need timed entry and exits as duration works only on falling rates and thus suit only informed investors. Accrual suits moderate and conservative investors as they do not have much volatility and are stable.

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’

What is driving liquidity in the markets?

The current rally in Indian market is fuelled by strong liquidity from domestic investors. With low bank fixed deposit rates, subdued real estate market (with high transaction cost) and stagnating gold prices, equities seems to be the most viable domestic investment avenue for investors. Thus in spite of the markets reaching all-time highs & rich valuations there is very strong cash inflows into the equity markets.
One observation is that domestic institutions have been flushed with funds ever since demonetization was announced and even till date the latest rally in equity markets is purely driven by excess liquidity. It may be a mere co-incidence but it could also be possible that the notes that were previously hoarded in homes & not in circulation is flowing into the equity markets after being deposited into banks.
Let us look at the different investment avenues in order of risk expected returns:


Liquid funds, ultra short term funds
Less than 1 year
Safe. Liquidity with some extra return over normal savings a/c. Taxable returns.
Bank FD
1-5 years
Safe & fixed returns. Marginally extra returns with liquidity but fully taxable other than 5 year FD.
3 years+
Returns not guaranteed. Moves in contrary to equities & does well in times of global distress.
Debt funds
1-5 years
Safe but returns may fluctuate. LTCG indexation if held more than 3 years.
Safe & fixed returns. Extra returns but illiquid. Mostly long term government savings schemes.
Hybrid funds
1-5 years
Marginally risky. Extra returns due to mix of equity & debt in the portfolio.
Real Estates
3 years+
Risky, returns may fluctuate. Illiquid long term investment. Transaction cost of buying & selling is very high (12-15%) & lengthy. LTCG indexation after 3 years holding
3 years+
Risky, returns may fluctuate. Capital appreciation, Liquidity. To achieve high priority long term goals. Tax free after 1 year.
The objectives above are in the order of priorities as well as return which means the liquid fund should be looked for first as liquidity then return, similarly while investing into equity one should keep the capital appreciation as top priority even if it offers liquidity that automatically sets condition for long term investing.
One should look at post tax real return i.e. (Real Return= Return-tax-inflation). Thus for each of the asset classes they should atleast beat inflation post tax to be viable. With inflation currently at ~3-4 all the above assets may be generating positive returns but bank FDs would be giving you the least post tax returns amongst all. (Assuming liquid funds are invested in for 3-6 months to take care of short term liquidity & not an attractive investment avenue).

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’