Debt funds have taken the mind share of investors after the recent run-up in debt while the Equities tanked. Thought will pen down few important Features, Risk Factors, Categories of Debt funds in different blogs, the one you are reading will talk about 2 important strategy of Debt funds.
Debt funds, broadly, follow one of the two strategies. One type of fund aims to make money out of predicting interest rate movements. Accordingly, it will buy and sell securities to have a particular maturity date of the portfolio. This strategy is called duration strategy. The second type of fund aims to invest in companies that have a lower credit rating but are well-managed. The intent here is to buy those companies where the fund manager expects credit ratings to improve, which will hopefully lead its price to go up and benefit the fund. This strategy is called accrual strategy. Many debt funds follow a bit of both strategies, depending on what their market view is. Choosing one over another has a bearing on the returns you could make and risks you take on.
Interest rate risk
Duration debt funds take a call on the interest rate scenario and position their portfolios accordingly. If they forecast interest rates to fall, they buy longer-dated bonds. If their calls go right, they benefit hugely. But if their calls go wrong, they make big losses. Accrual strategy funds don’t usually take interest rate risk, they stick to short- and medium-tenured bonds.
Credit risk
Accrual funds take on credit risk by buying companies that have a weak credit rating but strong fundamentals.
The strategy is: if the company is as well-managed as they think it is, its credit rating is bound to improve at some point. This uptick in credit rating will push up its price and the fund benefits. But if the company suffers from a downgrade in rating, the fund can suffer badly.
Debt Fund Merits
Debt funds can be invested for few days to few years, it’s better to choose the right fund depending on your time horizon and risk capacity. Debt funds score over Fixed Deposits for 2 reasons, 1st one being funds invested for more than 3 years attract lesser tax than certain tax slab and 2nd important factor is we can apply indexation for long term capital gains and reduce our tax outflow significantly. Please read this blog of mine to know more.
Apart from the above two, the most important factor which gives Debt funds an upper hand comparing Fixed Deposits is Compounding:
In a FD you pay tax on interest earned every year, this leaves lesser money to compound. In a debt funds no tax is deducted every year, you pay it only when you redeem. If held more than 3 years you get indexation benefit.
First time investor
Accrual funds carry a bigger risk because a fund manager who goes wrong on her duration call can recover relatively faster than had she taken—and suffered from—a wrong credit call. Defaults and downgrades of companies can be devastating, as it not only leads to losses, but spreads panic that results in massive outflows. Accrual funds, therefore, may be bought as a topping and not part of your core portfolio.
Recent closure of 6 Debt funds of Franklin Templeton is a good example, due to this trust factor is completely shaken and there were lot of redemption across categories of Debt funds and even in funds which were managed properly. Accrual and duration strategies serve their purpose for different goals and strategies. However, for a first-time investor, a duration strategy would be a safer bet.
Will write more on this subject in my next post, till then ⇒
Happy Investing!
R♥Vi
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