Accrual Funds

Accrual Funds are a category of debt mutual funds that primarily invest in fixed-income securities such as bonds, debentures, and money market instruments, with the objective of earning regular interest income (accrual) rather than capital appreciation. Unlike duration-based debt funds, which focus on profiting from movements in interest rates, accrual funds aim to generate steady returns by holding securities until maturity and accruing interest over time.
These funds are suitable for investors seeking stable income, lower volatility, and medium-term investment horizons, generally between two to four years.

Concept and Meaning

The term ‘accrual’ refers to the process of accumulating interest income that is earned but not yet received. In the context of mutual funds, accrual funds invest in interest-bearing instruments and accrue the interest periodically as income.
For example, if a bond pays 8% annual interest, the fund accrues a portion of that interest daily or monthly in its net asset value (NAV). Over time, this accumulation contributes to steady NAV growth, irrespective of short-term market fluctuations in bond prices.
Thus, the focus of accrual funds lies in interest accrual and credit spread capture rather than trading on interest rate movements.

Investment Strategy

Accrual funds typically invest in a portfolio of short- to medium-term fixed-income securities, including:

• Corporate bonds and debentures
• Non-convertible debentures (NCDs)
• Commercial papers (CPs)
• Certificates of deposit (CDs)
• Government securities (G-secs)

Fund managers target instruments offering higher yields, often by taking limited exposure to lower-rated but fundamentally sound issuers. This approach allows the fund to earn a credit spread premium—the additional return from investing in securities with slightly higher credit risk compared to top-rated instruments.
The typical objectives include:

• Generating consistent returns through accrued interest.
• Minimising mark-to-market risk caused by interest rate volatility.
• Balancing yield enhancement with credit risk management.

How Accrual Funds Work

The functioning of accrual funds involves three key components:

1. Interest Accrual: The interest earned on debt instruments is accrued daily, contributing to the gradual rise in the fund’s NAV.
2. Holding to Maturity: Most securities are held until maturity, which limits the effect of short-term interest rate changes on fund value.
3. Credit Risk Management: To earn higher yields, funds may invest in securities with lower credit ratings (for example, AA or A). While this enhances returns, it also increases the risk of default. Hence, effective credit analysis and diversification are vital.

Advantages of Accrual Funds

• Steady income generation: Designed to provide consistent returns through regular accrual of interest income.
• Lower interest rate sensitivity: Since the securities are held to maturity, the impact of interest rate fluctuations on NAV is reduced.
• Better yield potential: By investing in corporate and medium-rated papers, the fund can earn higher yields compared to government-backed securities.
• Diversification: Exposure to a wide range of issuers and instruments spreads credit risk.

Risks and Limitations

While accrual funds offer relative stability, they are not entirely risk-free. Key risks include:

• Credit risk: The most significant risk in accrual funds arises if an issuer defaults or delays payment. Funds holding lower-rated securities face higher potential loss.
• Liquidity risk: In times of market stress, selling low-rated bonds may become difficult, affecting the fund’s ability to meet redemptions.
• Concentration risk: Overexposure to a few issuers or sectors can magnify losses if defaults occur.
• Reinvestment risk: As securities mature, reinvesting at lower yields in a declining interest rate environment can reduce future returns.

Comparison with Other Debt Funds

Taxation of Accrual Funds

Accrual funds are treated as debt mutual funds for taxation purposes:

• Short-Term Capital Gains (STCG): If units are held for less than three years, gains are taxed as per the investor’s income tax slab.
• Long-Term Capital Gains (LTCG): If units are held for more than three years, gains are taxed at 20% with indexation benefits, which adjust the purchase price for inflation and reduce taxable gains.
• Dividends: If the fund declares dividends, they are subject to the applicable tax provisions based on the investor’s category.

Suitability for Investors

Accrual funds are suitable for:

• Investors seeking regular and predictable income rather than speculative capital gains.
• Conservative or moderate-risk investors with a medium-term investment horizon.
• Those looking to diversify portfolios by including fixed-income assets alongside equities.

However, investors should evaluate the fund’s credit exposure, issuer quality, and fund manager’s track record before investing.

Example of Return Dynamics

Suppose an accrual fund invests in corporate bonds yielding 8% annually and government bonds yielding 6%. The blended portfolio yield might be 7.5%. Over time, as interest is accrued, the NAV grows gradually—reflecting earned income.If no major defaults occur, the investor’s returns closely align with the portfolio’s yield, offering stable income without high volatility.

Evolving Role in Financial Markets

Accrual funds have gained prominence as investors seek alternatives to traditional fixed deposits. They offer potentially higher returns with moderate risk and liquidity. However, after past credit events in the Indian debt market (such as corporate defaults), fund managers and regulators have tightened credit selection norms to enhance transparency and investor protection.
The focus now lies on quality over yield, ensuring that investors achieve consistent performance without excessive credit exposure.