What is the difference between accrual and duration strategy?

Is investing in debt funds seeming complicated to you? Don’t worry; we are here to simplify it. Let us first start with the two types of strategies that fund managers adopt for different types of debt funds. On the basis of the strategy, broadly, there can be two types of debt funds- accrual based debt funds and duration-based debt funds. The returns and risks associated with any debt mutual fund may be determined on the basis of the strategy it adopts. The fund can either adopt one of the two or a mix of the above-said strategies to achieve its investment objectives. Before we detail out the strategies, let us first understand how debt funds work.

Debt mutual funds invest in fixed income securities like corporate bonds, Government securities, commercial papers, etc. These securities are called fixed-income because they come with a pre-declared maturity and the interest%. But that does not imply that the returns from debt mutual funds are fixed in nature. The returns can come from two sources. Firstly, the interest that the securities are generating. And secondly, any capital gains/loss from a change in interest rates. The second part involves expertise and is often dependent on prevailing interest rates in the market.

The bond’s yield is inversely proportional to the bond’s price. If the price rises, the yields fall, and if the interest rate gets cut, the bond price increases, thereby decreasing the yield. Let us understand this with an example. If you purchase a bond of price Rs 1000 at 8% interest and maturity of 5 years, the yield of your bond will be 8% of Rs 1000 i.e. Rs 80 per year. Now, when the market interest rate increases, the new bonds will be more lucrative than yours, and hence, your bond will trade at a lower price than the original face value. Suppose it is trading at Rs 950, then your yield shall become Rs 80/Rs 950= 8.421%. Similarly, if the bond price goes up in the case of an interest rate cut scenario, your yield will go down. Now, by varying the duration of the securities held in a debt fund, the fund managers may aim to gain an advantage from the interest rate changes. You can read more about how debt fund works,

Here is how the two strategies work-

The interest income from these securities can also be called accrual income. In this strategy, the fund manager aims to generate returns from the interest payments made by the securities it is invested in. So, the fund manager invests in securities and receives the interest accrued by them.

Accrual based debt funds can affect the credit quality of the securities that they invest in. The credit quality of any security determines the repayment capacity of the borrower. Securities with a higher credit rating are more secure but can offer lower yields; however, the ones with lower credit ratings can have the potential of higher yields. Accrual based funds can invest in a variety of such securities. For the lower-rated credit quality securities, the scheme can adopt a buy and hold strategy because the underlying securities are not very liquid in nature.

Okay, in simple words, and as established earlier in this article, the bond prices fluctuate with interest rate changes. That is to say that when the interest rates increase, the bond prices decrease and vice versa. As the bond prices increase, the NAV of the debt fund increases, and that is good news. But the longer the duration, more is the exposure to the interest rate fluctuation, and higher is the interest rate risk.

When a debt fund follows the duration strategy, the fund manager typically adjusts the duration of the underlying securities as per the interest rate scenario. If the interest rates are likely to fall, they may increase the scheme’s duration so as to benefit from the rising bond prices. On the other hand, when the interest rates rise, they may reduce the duration. In an environment when the interest rates are falling, a security with a longer duration will produce higher returns (due to an increase in bond price), and vice versa.

Hope the above information helped you gain a better understanding of investing strategy.

You can read more about the risks associated with debt mutual funds