Download Tax Saving Mutual Fund Application Forms
Invest In Tax Saving Mutual Funds Online
Leave a missed Call on
94 8300 8300
| What do bond fund managers mean when they talk of accrual and duration strategies? What's the difference between the two? When is accrual a better strategy than duration and vice-versa? How can we determine which one is suitable for our clients? | ||
| In order to understand and appreciate accrual and duration strategies, we need to step back one level and take a quick recap on interest rate cycles. As we all know, interest rates in an economy never remain static - they move up or down over time in response to the demand for and supply of money and the price that people are willing to pay for money at any point in time. RBI plays a key role in regulating supply of money through its monetary policy, with an aim to strike a balance between inflation and growth. In order to fuel growth during an economic slowdown, RBI will look to cut interest rates and induce borrowing to fuel growth and on the contrary, when fears of economic overheating are increasing, RBI will increase interest rates and curb money supply to deter excessive borrowing and rein in inflation. We have discussed this in some detail in the article on monetary policy All of these dynamics result in interest rates moving up and down quite substantially over a cycle, as can be seen from the graph below, which shows how the RBI repo rate has moved over the last 7 years.
Each phase of the interest rate cycle throws up different opportunities for fund managers to make money for their investors. These opportunities are influenced by two basic risks that we learn when understanding bonds : interest rate risk and re-investment risk. Interest rate risk We know that when interest rates rise, bond prices fall to reflect the higher yield in the market. Holders of bonds will suffer a capital loss on the value of the bonds. We also know that the extent of the loss is determined by the duration of the bonds - in general, bonds with many more years to go before maturity will see a sharper dip in the price than a bond that is due for maturity very shortly. The converse is equally true - when interest rates fall, bond prices rise. Longer duration bonds (in general bonds with longer periods to go before maturity) will see higher capital gains than bonds which are due for maturity in the near term. This has been discussed in some detail in the Jargon Buster article on duration Re-investment risk In a falling interest rate environment, you run another risk - that the maturity proceeds from a bond you were holding can now be reinvested at a much lower yield than the previous one. Conversely, in a rising interest rate environment, you will be happy to see that the maturity proceeds of a bond that's matured can be deployed into a new bond at a much higher yield. We see this all the time with even simple products like bank FDs. Why are all of these discussions relevant to understand accrual and duration strategies? That's because both these strategies are simply ways of optimising interest rate risk and re-investment risk, based on where in the interest rate cycle we are at the moment. Accrual strategy When adopting an accrual strategy, the fund manager typically looks for shorter duration corporate bonds that provide good yields. His focus is on getting returns through high accrual of interest on the bonds that he holds. He is not shooting for making money from capital gains on a rise in bond prices. He would rather focus on extensive credit analysis to identify corporate bonds that offer attractive yields, and which in his view offer adequate comfort of timely payment of interest and repayment of principal. Generally, in a rising interest rate environment, the fund manager would not want to be locked into high duration bonds which can see a sharp erosion in prices as interest rates fall. Rather, he would like to keep the duration at the minimum, since he is likely to get higher yields on maturity of existing bonds, so long as they are maturing in the near term. If duration has to be minimised to avoid interest rate risk, the focus will shift to searching for short duration corporate bonds that can fetch a higher yield than government bonds of similar maturities. 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. You will often find accrual based funds that allow the fund manager to run a portfolio with an average maturity of anything between say 1 and 3 years. When interest rates are rising rapidly, the fund manager will seek to keep the average maturity closer to 1 - which not only safeguards against interest rate risk, but also helps him reinvest maturity proceeds at more attractive levels. Conversely, in a falling interest rate environment, the same accrual based fund - which primarily focusses on buying high yielding - acceptable quality corporate bonds, will also make a subtle shift in its stance by going all the way up to 3 years duration. This allows the fund manager to earn moderate capital gains when bond prices rise in response to fall in interest rates. This capital gain helps offset the reinvestment risk that the fund runs in a falling interest rate environment. Duration strategy A fund manager who employs a duration strategy is one who takes a call on the direction of interest rate movements and accordingly focusses on adjusting the duration of his portfolio to maximise returns. He is less focussed on searching for corporate credits with high accruals - he would rather cut out the entire credit risk aspect, stick to government bonds, but focus on managing duration to drive returns. In periods of declining interest rates, he would opt for a relatively high duration, in an effort to maximise capital gains from rising bond prices. Conversely, in periods of rising interest rates, he would minimise the duration of the fund to protect against capital losses on the portfolio. This not only protects against capital losses, but at the same time, allows him to reinvest maturity proceeds at higher yields in a rising rate environment. In other words, the higher accruals are aimed at offsetting capital losses, to enable the fund to deliver a reasonable return. Which one carries higher risk? Each strategy carries its own risk. An accrual strategy, if pursued too aggressively, can increase credit risk in the portfolio, in the quest for higher yields. You need to take a judgement call on the credit evaluation processes and expertise that the fund manager and the fund house has, in order to evaluate whether their processes are robust enough to avoid credit accidents. You will need to also evaluate the portfolio in terms of ratings profile of the securities held and arrive at your independent conclusions on whether you think the credit risk taken is acceptable or not. On the other hand, a duration strategy entails more of an interest rate risk, or a risk of volatility in near term interest rate movements, rather than a credit risk. Even in a declining interest rate environment, there is rarely a smooth and uniform decline in market yields. Yields gyrate quite a lot around the trend line and these gyrations can cause short term dips in the NAVs of duration based funds, much more than they do for accrual based funds. How should we determine suitability for clients? Duration based strategies are likely to see NAVs fluctuating much more than accrual based strategies, but at the same time, in declining interest rate environments, hold the promise of higher returns than accrual based strategies. The key therefore is to understand the risk appetite and objectives of your clients in determining whether to go for accrual or duration based strategies. Accrual based strategies offer a little more predictability in returns and can be selected for more conservative investors, so long as you as the advisor are comfortable with the credit appraisal processes of the fund house. Accrual strategies can remain relevant for long periods of time, and need not necessarily be reviewed by you at different stages of the interest rate cycle. In contrast, duration strategies are perhaps better off only in periods of declining interest rates, and may disappoint in times of rising interest rates. As an advisor, you may have to monitor these funds a little more closely. These are therefore suitable for clients whose portfolios you are in a position to review once a quarter. In order to smoothen returns from duration based strategies, fund managers are increasingly recommending dynamic bond strategies - where the fund manager recognises these risks and makes appropriate changes in portfolio composition, in line with the changing phases of the interest rate cycle. Investors whose portfolios you may not be able to review frequently, may be better advised to consider dynamic bond funds within the duration space rather than pure long duration funds. | ||
For further information contact Prajna Capital on 94 8300 8300 by leaving a missed call
Leave a missed Call on 94 8300 8300
Leave your comment with mail ID and we will answer them
OR
You can write back to us at
PrajnaCapital [at] Gmail [dot] Com
---------------------------------------------
Invest Mutual Funds Online
Download Mutual Fund Application Forms from all AMCs
Download Mutual Any Fund Application Forms
---------------------------------------------
Best Performing Mutual Funds
- Largecap Funds Invest Online
- DSP BlackRock Top 100 Fund
- ICICI Prudential Focused Blue Chip Fund
- Franklin India Bluechip
- ICICI Prudential Top 100 Fund
B. Large and Midcap Funds Invest Online
- ICICI Prudential Dynamic Plan
- HDFC Top 200 Fund
- UTI Dividend Yield Fund
- Birla Sun Life Front Line Equity Fund
- Franklin India Prima
C. Mid and SmallCap Funds Invest Online
- Reliance Equity Opportunities Fund
- DSP BlackRock Small & Midcap Fund
- Sundaram Select Midcap
- IDFC Premier Equity Fund
- Birla Sun Life Dividend Yield Plus
- SBI Emerging Businesses Fund
- HDFC Mid-Cap Opportunities Fund
- ICICI Prudential Discovery Fund
D. Small and MicroCap Funds Invest Online
- DSP BlackRock MicroCap Fund
2. Franklin India Smaller Companies
E. Sector Funds Invest Online
- Reliance Banking Fund
- Reliance Banking Fund
- ICICI Prudential Banking and Financial Services Fund
F. Tax Saver Mutual Funds Invest Online
1. ICICI Prudential Tax Plan
2. HDFC Taxsaver
- DSP BlackRock Tax Saver Fund
- Reliance Tax Saver (ELSS) Fund
G. Gold Mutual Funds Invest Online
- Relaince Gold Savings Fund
- ICICI Prudential Regular Gold Savings Fund
- HDFC Gold Fund
- Birla Sun Life Gold
H. International funds Invest Online
1. Birla Sun Life International Equity Plan A
2. DSP BlackRock US Flexible Equity
3. FT India Feeder Franklin US Opportunities
4. ICICI Prudential US Bluechip Equity
5. Motilal Oswal MOSt Shares NASDAQ-100 ETF
No comments:
Post a Comment