Duration of Accrual: What’s your debt fund strategy?
There is so much that is written about equity funds, that debt funds seldom get enough limelight. This time, we bring to you the nuances of debt fund investing. Most debt fund managers use 2 strategies to generate gains from their investment, namely, the duration and accrual strategy. Here we understand how these strategies differ and the means to make the best out of these strategies. However, before we embark on understanding the strategies, it is customary that we understand what debt funds are!
Debt mutual funds, often referred to as debt funds invest in fixed income instruments, these could range from Treasury bills, Government Bonds, Corporate Bonds, and money market instruments etc., The investment will yield interest or fixed income and/or capital appreciation. Debt funds are also referred to as fixed-income funds, their cash flow is less volatile and often you have an idea regarding the possible returns that can be generated from the investment.
The advantages of investing in debt mutual funds are over other debt instruments are manifold:
- High liquidity in contract to other debt instruments where the tenure is fixed
- Higher tax efficiency in comparison to other debt instruments
- Access to debt instruments such as money market instruments which is not accessible to retail investors otherwise due to the high minimum investment amount.
- Ability to invest in a systematic format each month to channelize your savings.
It is a good option for someone who intends to gain a regular income and is also risk averse. Even the most elite investors have a part of their funds in debt to ensure that it can be pulled out in case of emergency. For unforeseen circumstances, having funds in debt can help you leave the rest of your investments unperturbed. However, veterans know to play the debt market well to generate substantial gains.
Often, investors in debt with a duration strategy have an eye on the interest rate movement. This is a strategy where the fund manager will have an interest rate outlook. The duration of the holding is actively managed under this strategy. Let’s understand this with a scenario:
If the fund manager foresees the interest rates are likely to fall, he will maintain a long position in the intended debt fund (here this is achieved by investing in a Long-duration funds / Medium to Long duration funds / Gilt Funds / Dynamic Bond Fund where the underlying instruments are of a long-term nature, 5 – 10-year bonds etc.,). When the interest rates are likely to fall, the investment strategy is to hold a long position by investment in a long-term paper, this is relative to the benchmark, as the focus of any investor/fund manager would be to outperform the benchmark. When the interest rates fall the long positions held will generate capital appreciation, as the bond prices of long-term bonds tend to go up when the interest rates fall.
On the contrary, if the interest rates are likely to go up, then a short duration has to be maintained concerning the benchmark. The fund manager’s position is always in relation to the benchmark, as the focus is to generate alpha (excess returns as compared to the benchmark).
You must note that the long and short are used in debt funds in the context of the duration of underlying instruments and not from the perspective of buying and selling positions as in the case of equity funds
This strategy differs drastically from that of the duration strategy, the focus here is to earn interest income based on the coupon offered by the underlying instruments from the debt fund held. There is an emphasis on taking advantage of the mismatch in credit quality. Typically, a company with a lower credit quality will offer a higher coupon, as they do not stand the credibility of borrowing at competent rates like the ones that have superior credit quality.
Under this strategy, the fund manager will invest in debt funds with instruments which have lower credit ratings, these instruments provide better coupons than the ones with higher credit ratings. On the other hand, the fund manager speculates that the company’s prospects may improve in the future, which would lead to a revision of credit rating, which could potentially increase the bond prices. Thus, the fund manager can achieve the dual benefit of generating higher coupon yields and possible capital appreciation in the future. It is also pertinent to note that duration strategy is not just about investing in credit risk funds, it is also about altering the duration of holding of a range of funds including corporate bond funds, banking and PSU debt funds etc.,
Both these strategies may be used in appropriate proportion by the fund manager to generate optimal returns. It is important to note that there are severe pitfalls under both strategies, especially so if the economic scene does not pan out as intended.
It takes a trained hand to tactfully execute debt fund strategies, you can reach out to experts at TATA CAPITAL who can help you include the appropriate debt funds in your portfolio which will generate optimal returns and align with your risk profile.