'Accrual funds could be good for investors from risk/reward perspective'

Franklin Templeton believes the short end of the curve continues to offer the best risk-reward to the investors.

The confluence of global factors has turned positive for fixed-income markets, for now, according to global investment firm Franklin Templeton. 

After the US Fed chair indicated that it is open to dialling back the amount of policy restraint in place, the rally in global yields intensified. Oil prices too, have remained benign despite geopolitical turmoil as OPEC supply cuts have been countered with non-OPEC increase in supply and fears of an impending slowdown. 

Franklin Templeton believes the markets have already priced in 100-150 bps of rate cuts from the major developed market central banks such as the US, UK and EU. However, core inflation for these geographies continues to stay elevated relative to targets with the last mile of disinflation dependent on sticky services inflation. The fiscal deficit in the US continues to run at a high level despite strong economic growth and low unemployment levels. "We believe that the markets seem to be running ahead of fundamentals and this is likely to create volatility in the months ahead," said Rahul Goswami, CIO - Fixed Income at Franklin Templeton.

With commodity prices benign, the brokerage expects inflation to move towards the centre of RBI tolerance band over the next year. Food items form nearly half of the CPI basket and thus RBI would continue to be watchful of this volatility seeping into inflationary expectations. Also, the monsoons this year could again be impacted by the ongoing El-Nino phenomenon.

"We anticipate that domestic growth resilience could continue to be sustained through the government's focus on manufacturing and benefits of global supply chain reorganization favouring India. A pick-up in rural demand alongside a

private investment revival could further provide fillip to growth. In our view, the government can maintain the fiscal impulse in case it is able to reduce its fiscal deficit through asset sales. RBI MPC is likely to keep policy rates

steady with some probability of a shallow rate cut moves in 2HCY24. We do expect, however, that the MPC would drop the “withdrawal of accommodation” stance somewhere in the next few policy meetings and move to a “Neutral” stance," said Goswami. 

Goswami believes the short end of the curve continues to offer the best risk-reward to the investors. 

"We have been adding duration to our funds and will continue to do so on an opportunistic basis. Exposure to the longer end of the curve would largely be a part of tactical positioning, for now. Accrual-based products could be good choice for investors from the risk/reward perspective," said Goswami. 
 

Accrual funds are low risk investments, and typically invest in short to medium maturity plans. As per Cleartax, they take credit risk and invest in lower-rated securities for the sake of generating a higher yield. The main aim of accrual funds is to earn interest income in terms of coupon offered by bonds. These funds adopt buy and hold strategy and, and hold the assets till maturity. They also focus on generating better returns compared to bank FDs.

Point to note: Accrual debt funds are less volatile than duration-based debt funds. The accrual fund strategy is relatively more predictable in returns. So a conservative investor with a low-risk appetite can opt for this.

Accrual Strategy explained

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," explained Nippon Mutual Fund. 

"Accrual Funds are an ideal investment option for investors who have a viewpoint about the interest rate movements. Ultra short term bond Funds, FMPs, and Short Term Bond Funds follow this strategy. If an investor needs a steady return from his debt Portfolio and is not ready to take higher risks, should ideally invest in accrual-based funds. These funds are suitable for investors who want to earn desire stable returns. It is advised to invest in Accrual Funds for least a 1-3-year horizon," according to Fincash, an online investing platform.

Duration Strategy

 Duration-based strategy invest in long-term bonds and benefit from the interest rates fall. They earn from capital appreciation along with the coupon of the bond. But, these funds are exposed to interest rate risk and these funds can bear capital losses, if the interest rates move up. Generally, when the interest rates are going down, the duration fund manager chooses a relatively high duration, so as to, maximize Capital Gains from the rising bond prices. Duration-based funds are only good when interest rates decline and needs close monitoring.

 "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 to benefit from the rising bond prices. On the other hand, when the interest rates rise, they may reduce the duration. In an environment where 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," explained Nippon. 

Risks to Franklin Templeton's outlook could potentially emanate from key factors such as geopolitical risks, the recurrence of El-Nino, any spike in energy and commodity prices and surprise election outcome in India and the US.

India is entering a phase of multi-year capex cycle. " Growth is expected to be driven by domestic consumption, premiumization of consumption, infrastructure and capital investment. Capex boost would be led by continued momentum in government spending, uptrend seen in private sector capex and household capex growth. (c) Green transition – opportunities to emerge as the economy moves towards net zero target of 2070. New opportunities are emerging in Gen-AI, new energy businesses, digital space which need to be tapped. Strong DII support on the back of retail flows to the markets has been a structural change supporting the markets over the last few years," said R. Janakiraman, CIO – Franklin Equity.

Despite fundamental strength in the Indian economy supporting domestic equities over medium term, the investment firm cautioned that uncertainty in global factors could potentially keep markets volatile in the near term. 

"While investors may continue to invest as per their specific risk appetite and investment goals, they may seek incremental diversification in terms of asset class, geographies and investment style (increasing exposure to value style) for their portfolios. In addition, investors could seek to invest in businesses with strong balance sheets and sound business models. It is recommended to consider staggered investment in diversified fund categories," said Janakiraman.