Accrual Funds
All of us at some point in our lives have been on long journeys by road or rail. There are two ways of approaching any journey.
1. Travel at a consistent speed from point A to B.
a. This approach could lead to considerable fuel efficiency if the roads/rail track are good for a long stretch
b. However if the roads/rail are not consistent then you could have a huge repair bill or you could be slow or given the consistent effort you could be dead tired by the time you reach destination.
2. Another way is to break the journey into short or medium distance stages.
a. This would allow you to drive your vehicle at the speed which is optimum for that stage.
b. This strategy also allows you to enjoy the sights, sounds and food of the places in between.
c. This strategy also allows for course correction should anything go wrong.
d. Last but not the least it gives you a better shot at reaching the destination refreshed or at least less tired.
The process of investments can also be described as a journey which we take to achieve a financial objective.
If the economic environment and as a corollary the interest rate environment is expected to be consistent for long periods of time then it is advisable to invest consistently in a long duration product somewhat similar to the first approach.
However, we all know that in the current situation our economy is displaying a sense of volatility. In this kind of an environment, it is advisable to follow the second approach i.e. investing in securities,which are near to maturity to reduce the impact of interest rate shocks. This approach in investing parlance is termed as accrual approach.
The accrual strategy involves investing in safe, short-term bonds and money market instruments.
This strategy is especially successful in cases where securities which are expected to mature within a year or two are selected to reduce any turbulence volatile environment exposes the investor to duration risk — Duration is a measure of how sensitive the price of a bond is to change in interest rate, and is expressed in years. Longer the maturity of a bond, the more sensitive is the bond’s price to the changes in interest rates.
By holding short to medium-term instruments, the accrual strategy explicitly avoids duration risk. Also, by investing only in safe, investment grade instruments, and holding till maturity, the strategy protects investors from volatility as well as default risk.
Thus,any fund which intends to generate returns predominantly through accruals provides stability to returns. These funds have ability to generate returns which are more predictable and provides avenue for investors who are looking for earning stable returns over a long period.