How Accrual based debt funds are different from Duration based debt funds?

If flying thrills, you then I am sure that given a chance to enter the cockpit of an aeroplane, you would certainly want to see how the aircraft is flown.

Similarly, investors would be fascinated to learn about the concepts which fund managers apply to manoeuvre their money through different economic environments.

Table of Contents:

• Genesis of Debt Funds
• Fund Managers and Debt Fund Strategies
• Accrual fund Strategy
• Duration fund Strategy
• Risk in Accrual Debt Funds Vs Duration-Based Debt Funds
• Risk Assessment
• Which one to choose?
• Conclusion

Genesis of Debt Funds

Debt Funds , as we all know, are a class of mutual funds where investments are made in fixed interest bearing securities like Government Securities, Treasury Bills, Corporate Bonds, Money Market instruments and other debt securities of different time horizons.

Generally, debt securities pay a fixed rate of interest and have a fixed maturity date.

In simple terms, debt funds are designed for investors who want predictable returns with relatively lower risk compared to equities, and they can be managed using strategies like accrual funds or duration funds.

Fund Managers and Debt Fund Strategies

The fund manager adopts either of two different strategies while managing debt funds. They are:

1. Accrual fund strategy
2. Duration fund strategy

1.Accrual fund Strategy

When fund managers look to purchase corporate bonds with high yields, they are actually focussing on garnering high accrual of interest.

Their research will entail extensive credit analysis for identifying corporate bonds that offer attractive yields and at the same time is sure to make timely payment of interest and principal.

This is why accrual mutual funds are often considered suitable for investors looking for stable interest income rather than betting on short-term interest rate movements.

In other words, the search for returns is dictated by a trade-off between yield that he can get on corporate bonds and the credit risk he is taking by buying these higher interest bearing (and possibly lower credit rated) corporate bonds.

The accrual fund manager will not change the duration and average maturity of his holdings.

The accrual fund manager will keep them in a particular range forever.

So the accrual fund manager will choose debt instruments which will fit into his duration and average maturity.

Also the accrual fund manager will hold these securities till maturity.

Even if the interest rate fluctuates and Nav drops, it will be a temporary phenomenon.

The drop in nav will become a real loss for the accrual fund only when the security is sold at a discount.

As the securities are held till maturity, there will not be any actual loss due to interest rate fluctuations.

Hence, the accrual strategy in debt funds focuses on the interest income or “accruals-based” returns rather than capital appreciation through trading bonds.

This in essence is the Accrual fund Strategy for bond investments.

For example, if a fund manager invests in a 5-year corporate bond with an annual coupon of 8%, the investor will continue to receive that fixed income until maturity, irrespective of interest rate fluctuations.

This makes accrual funds meaningfully different from duration-based funds.

2. Duration fund Strategy

When a fund manager adjusts the duration of his portfolio to optimize his returns and when such decision is based on the direction of the interest rate movements, then the fund abides by the duration strategy.

Fund managers who opt for the duration strategy are less focussed on searching for corporate credits with high accruals.

Their focus is strongly on managing the duration so as to maximize returns.

When the interest rates are going down, the duration fund manager opts for a relatively high duration so as to maximise capital gains from the rising bond prices.

In the opposite scenario, where interest rates are rising, the duration of the fund would be minimised so as to protect against capital losses on the portfolio.

The duration fund manager takes speculative calls on the interest rate movements and increases or decreases the duration and average maturity frequently.

As the interest rates move based on too many variables, it is practically very difficult for a duration fund manager to predict the interest rate movements correctly.

The wrong predictions make the duration based debt funds suffer a lot.

In other words, duration strategy in debt funds is more about “timing” the interest rate cycle, unlike accruals-based investing where the focus remains on holding bonds till maturity.

Risk in Accrual Debt Funds Vs Duration-Based Debt Funds

Every investment strategy comes with its own set of risks — and debt funds are no exception.

While both accrual funds and duration funds aim to deliver returns from fixed-income securities, the type of risk exposure differs significantly between the two.

i. Risks in Accrual Debt Funds

Accrual debt funds primarily focus on earning steady interest (accruals) by holding bonds till maturity.

At first glance, this may appear to be a safe strategy, but it isn’t risk-free.

• Credit Risk (Default Risk):
  The biggest risk is that the bond issuer may delay or fail to pay back interest or principal. This is more likely if the fund manager chases higher yields from lower-rated companies. For instance, if a company defaults, the entire accrual strategy suffers because the interest income expected will not materialize.
• Liquidity Risk:
  If the fund manager wants to sell a bond before maturity, there may not always be enough buyers in the market. This can force the manager to sell at a discount, impacting the NAV.
• Concentration Risk:
  If too much of the portfolio is invested in a few issuers (say 3–4 companies), a single credit downgrade can hurt the entire fund’s performance.
• Interest Rate Risk (Minimal):
  Since accrual funds generally hold bonds till maturity, they are less sensitive to interest rate changes. However, temporary NAV dips may still occur when rates move up, though these usually recover over time.

Accrual bond funds carry higher credit risk but lower interest rate risk.

ii. Risks in Duration-Based Debt Funds

Duration funds, on the other hand, rely on timing interest rate cycles to generate capital gains.

This makes them highly sensitive to economic conditions.

• Interest Rate Risk (Primary Risk):
  Duration funds face the maximum impact when interest rates rise. Bond prices fall, leading to an immediate dip in NAV. For example, if RBI unexpectedly raises repo rates, long-duration funds can see sharp short-term losses.
• Market Timing Risk:
  Duration strategy assumes that the fund manager can correctly predict rate movements. But in reality, interest rates depend on multiple factors like inflation, global markets, and government policies. Wrong calls can significantly hurt returns.
• Volatility Risk:
  Since bond prices move inversely with interest rates, duration-based debt funds show higher NAV volatility compared to accrual funds. Investors with a low-risk appetite may find this instability uncomfortable.
• Credit Risk (Minimal):
  Unlike accrual funds, duration strategies usually stick with safer government securities and high-quality bonds. So, credit risk is relatively low.

Duration-based funds carry higher interest rate risk and volatility, but lower credit risk.

Risk Assessment

Every investment has its own associated risk and this applies to all strategies which fund managers may choose to adopt.

It is an age old adage that “too much of anything is bad”.

A very aggressive perusal of accrual fund strategy, in the quest for higher yields can be counter-productive.

This can lead to credit accidents if the credit-analysis is not properly done.

A thorough evaluation needs to be done by the accrual fund manager and necessary conclusions be drawn before the quantum of commitment to accrual fund strategy is decided.

Duration strategy is more about interest rates and their associated volatility rather than credit risks.

It is often noticed that even when interest rates are on a down swing, the market yields do not entirely much such a dip.

Yields are seen to move around trend lines and these movements can cause the Net Asset Values to dip in the short run for duration based funds to a far greater extent that accrual based funds.

This shows why understanding accrual strategy vs duration strategy is crucial for investors before committing to debt funds.

Which one to choose?

The suitability of a particular strategy based fund is dependent on the risk appetite and objectives of the clients.

The following is a checklist of the key features of the individual strategy based funds:

• More volatility in NAVs’ for duration based funds than accrual based funds
• Duration based funds are more likely to yield higher returns in a declining interest rate economy.
• Accrual fund strategy are comparatively more predictable in returns and can be a choice for the conservative investor.
• Accrual fund strategies are more stable in the sense that they remain relevant for long periods of time and need not be reviewed during different cycles of interest rate changes.
• Duration based funds are only good when interest rates decline and needs close monitoring.
• Fund managers often temper the risks of duration based bonds by suggesting dynamic bond strategies where a change in portfolio mix is suggested based on the fluctuations of the interest rates.

Put simply, accrual funds meaning lies in earning steady coupon income, while duration funds are driven more by speculation on debt duration and interest rate cycles.

Conclusion

A more risk-averse client would certainly choose to opt for accrual strategy based funds due to its inherent stable nature.

We choose debt funds as an alternative to fixed deposits.

In that case going for accrual based debt funds makes more sense.

Accrual debt funds are thus seen as a predictable option, while duration funds may work well for those willing to take higher interest rate risks for potential capital gains.

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How accrual based debt funds are different from duration based debt fund in your point of view.

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