Understanding Duration And Accrual Strategies

What is Duration?

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond's duration is easily confused with its term or time to maturity because they are both measured in years. However, a bond's term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand is non-linear and accelerates as time to maturity lessens.

There are two types of duration: Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows, and should not be confused with its maturity. Modified duration measures the price change in a bond given a 1% change in interest rates. A fixed income portfolio's duration is computed as the weighted average of individual bond durations held in the portfolio.

Understanding Duration
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates. In general, the higher the duration, the more a bond's price will drop as interest rates rise (and the greater the interest rate risk).

The factors affecting a bond’s duration are:

• Time to Maturity: The longer the maturity, the higher the duration, and the greater the interest rate risk. A bond that matures faster—say, in one year—would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.
• Coupon Rate: A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower coupon rate. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

Long and Short Duration Strategies
A long-duration strategy describes an investing approach where a bond investor focuses on bonds with a high duration value. In this situation, an investor is likely buying bonds with a long time before maturity and greater exposure to interest rate risks. A long-duration strategy works well when interest rates are falling, which usually happens during recessions.

A short-duration strategy is one where a fixed-income or bond investor is focused on buying bonds with a small duration. This usually means the investor is focused on bonds with a small amount of time to maturity. A strategy like this would be employed when investors think interest rates will rise or when they are very uncertain about interest rates and want to reduce their risk.

What is Accrual Strategy?
An accrual strategy aims to primarily earn regular interest income from the investment made and ideally seeks to hold the paper until it matures, other things remaining the same. Funds that use this strategy are also called ‘income’ funds as their primary strategy is to receive regular income from the papers they hold.

An accrual strategy is typically adopted by fund managers in instruments with short to medium term maturity. This is because of three reasons:

• Locking in very long-term interest rates is advisable when they are the highest
• Locking for the long term, other than in government securities, could spell unforeseen credit risk in future
• Long term exposes the papers to interest rate vagaries and hence more prone to volatility. They do not thus make for predictable returns

What is an Accrual Bond?
An accrual bond's interest is added to the principal balance of the bond and is either paid at maturity or, at some later date, when the bond begins to pay both principal and interest based on the accrued principal and interest to that point.

A traditional bond involves making periodic interest payments to bondholders in the form of coupons. The interest is paid at scheduled dates until the bond expires, at which point, the principal investment is repaid to the bondholders. However, not all bonds make scheduled coupon payments. One such bond is the accrual bond.

An accrual bond defers interest, usually until the bond matures. This means interest is added to the principal and subsequent interest calculations are on the growing principal. In other words, the interest due on the accrual bond in each period accretes and is added to the existing principal balance of the bond due for payment at a later date.

Why Accrual Strategy?
Accrual strategy has the following advantages:

• Predictability: As interest income keeps adding to the NAV steadily, there is predictability of returns. For most overnight and liquid funds, if the residual maturity (average remaining tenure of the underlying papers) is known and YTM while investing, a fair idea of return can be expected over that residual maturity.
• Less Volatility: There is less volatility in accrual funds primarily because they are of very short or medium duration. As shorter duration instruments are less sensitive to interest rate moves than longer duration papers, the investor will experience less swings in the fund’s NAV.       

Categories of Accrual Strategy in Mutual Funds
The following are the categories of accrual strategy in mutual funds:

• Liquid category: In the liquid category features the overnight funds and liquid funds in which the average maturity doesn’t exceed 90 days. They have the lowest risk interest rate risk and are suitable for parking of surplus funds for a very short period of time.
• Liquid plus category: In this category features ultra-short duration funds, low duration funds and money market funds. In these funds, the average maturities range from 3 to 12 months depending on the sub-category. These too are suitable for short term parking of funds as they have low interest rate risk and thus experience less volatility.
• Others: The other sub-categories that feature here are corporate bond funds, banking and PSU debt funds and credit risk funds. These funds have higher maturities, usually more than 2 years and thus can be more volatile compared to the liquid and liquid plus categories with respect to interest rate risk. However, credit risk funds carry credit default risk which an investor should be aware of.

Accrual funds are not entirely immune to the effects of rising interest rates, especially when the rise is steep and fast, but the impact is far lower than on duration funds.

Key Takeaways

• Duration helps understand the relation of bond prices to the change in market interest rates
• The longer the maturity, higher is the duration of the bond. Conversely, higher the coupon rate, lower is the duration of the bond
• A long-duration strategy works well when interest rates are falling, and a short duration strategy is more suitable when interest rates are expected to rise
• Accrual strategy is to earn regular interest on the bonds and are ideally to be held till maturity
• An accrual bond's interest is added to the principal balance of the bond and is either paid at maturity or, at some later date
• Accrual strategy offers predictability due to the regular interest income and is less volatile as such funds are of very short or medium duration

This material is part of an Investor Education and Awareness Initiative of Canara Robeco Mutual Fund