Debt fund managers primarily use two strategies to generate gains. Understanding how the strategies work makes it easier for investors to appreciate the risk-return tradeoff of investing in debt funds.
The two debt fund strategies are:
The duration strategy involves investing in debt with an eye on interest rate movements. This is a deliberate strategy wherein the fund manager makes interest rate calls. The focus is on active duration management.
For instance, when the fund manager is of the view that interest rates could fall, he maintains a long position in the fund (by investing in long term paper) relative to the benchmark. This will help maximize capital appreciation, as when interest rates fall, the prices of bonds go up. When he believes interest rates could go up, he maintains a short duration relative to the benchmark.
The accrual strategy is about focusing on earning interest income from the coupon offered by the securities held in the portfolio. Another way of looking at accrual funds is taking advantage of the mismatch in credit quality.
The fund manager invests in debt that has lower credit rating. He is bullish on the company’s prospects and expects it to get a higher credit rating in the future. This should see the bonds prices of the company rise at the time of re-rating.
It is common to find debt fund managers employ a bit of both strategies for optimum results. Accrual strategy is less risky compared to duration strategy
Let’s discuss the various trade-offs associated with the two strategies:
a. Credit risk
Practioners of the accrual strategy take on credit risk since the strategy stands to benefit from credit re-rating of companies in its portfolio. If the companies do not perform as expected, they could be in for a downgrading. This could hurt the debt fund’s performance.
b. Interest rate risk
Duration strategy involves taking active bets on the movement of interest rates (either upwards or downwards).
If the fund manager believes rates will rise, he aims his guns on short-term paper since they can tide over a rise in interest rates.
If he forecasts falling interest rates, he sets his sight on longer term paper, since they benefit from a rate cut.
If the fund manager’s call on interest rates does not work out as expected, fund performance could take a hit.
c. Regular income
If investors are looking for income at regular intervals, debt funds pursuing accrual strategy are an option. Although debt funds do not assure regular income (dividends), the long-term nature of the accrual strategy is geared to generate income at regular intervals.
The duration strategy given its fleeting nature provides benefits that are short-lived vis-à-vis the accrual strategy.
Accrual or Duration?
Accrual funds focus on higher yields. This strategy is best suited for investors with a short time horizon with a regular income and less risk. Duration funds, on the other hand, take on interest rate risk. They are therefore ideal for investors who can tide over volatility associated with duration strategy. Duration funds can generate better returns when interest rates decline.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.