Use accrual strategy in volatile debt markets

Accrual strategy is to buy a bond & hold it till maturity and earn interest income

To beat volatility in equities, the recommended strategy is systematic investment plans or buy when the market falls to average out costs. Similarly, in the debt market, following the accrual strategy can help you beat the volatility of the debt market. 

While investing in bonds, investors can make money either through capital appreciation that is buying and selling, or through interest payout. The latter strategy is accrual, that is, to buy a bond and hold it till maturity and earn from the accruing of interest.

Since the Reserve Bank of India (RBI) started tightening liquidity, debt markets have turned volatile.

This has made investors risk averse. “It has become difficult to gauge how long this volatility will continue,'' says Dhruva Raj Chatterji, senior investment consultant, India Morningstar Investment Management.

 
Such investors can look at funds which follow the accrual strategy, where the income gets accrued, such as an ultra short fund. These are less volatile than an income fund or a bond fund. While investing in such funds one should look for funds which have lower expenses and are highly rated, rather than returns, because the returns are likely to fluctuate. “Usually funds which have a lower expense ratio, tend to give higher returns. These are already built into the net asset value,” Chatterji says.

For an accrual strategy, make sure the modified duration of the debt fund should be less than two years, since it is a foreseeable future says Feroze Azeez, India-director and head, investment products, at Anand Rathi Private Wealth Management.

Also, make sure the exit load of the fund has some co-relation to the average duration of the bonds that the fund invests in or the exit loads are steep to deter investors from redeeming these before maturity.

For instance, if the fund buys bonds with an average life of three years, then according to the accrual strategy, the fund manager should hold the fund till maturity. But if the exit load is applicable for only six months, there could be investors who want to redeem after this holding period. So, the fund manager will be forced to sell the bonds and this will be contrary to the investment strategy.

“These funds don’t invest in government securities. They invest in corporate bonds which don’t have very high liquidity. So, if these are sold before maturity, they will not offer the right price,” Azeez says.

Since these funds invest in corporate securities, investors must look at the credit quality of the underlying papers, says, Amarendra Phatak, director-sales, private wealth, Ambit Capital.

“The yield-to-maturity of these funds currently stands at about 11-11.5 per cent. The accrual strategy is good for an investor with an investment horizon of 12–18 months, since now the view is that there is volatility in short-term rates. Even if there is rate cut within one year, investors will get appreciation in the fund’s value,” Phatak says.

Fixed maturity plans (FMPs) are one end of the accrual strategy, since they are closed-ended funds and the duration is usually one-two years. But even within the open platform there are specific funds that follow the accrual strategy which one can look at.