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Medium term accrual debt funds a superior alternative to FMPs

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Accrual funds are those debt funds which hold short- to mediumterm debt instruments in the portfolio. By investing only in safe and highly rated instruments, fund managers in these funds minimize the credit risk of the portfolio.


When adopting an accrual strategy, the fund manager typically looks for shorter maturity securities that provide good interest yields. Because these funds don't seek to earn income by buying and selling bonds, the strategy is protected from high volatility. The focus is on getting returns through high accrual of interest on the securities that the fund holds.


You will often find accrualbased funds having an average maturity of anything between one and three years. When interest rates are rising rapidly, the fund manager will seek to keep average maturity closer to one year which not only safeguards against interest rate risks, but also helps him/ her reinvest maturity proceeds at more attractive levels.


Conversely, in a falling interest rate environment, the fund manager will also make a subtle shift in the fund's stance by going all the way up to three years maturity. This allows the fund manager to earn moderate capital gains when bond prices rise in response to fall in interest rates. The capital gain helps offset the reinvestment risk that the fund runs in a falling interest rate environment.


Accrual-based strategies offer very high predictability in returns and can be selected even for the most conservative investors. Also, 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.


Since the medium-term debt fund on an average delivers around 9% yearly return, which is broadly in line with the inflation index under the Income Tax Act, it results in zero taxable capital gains and hence almost nil tax on earnings from such funds.
The following reasons make these funds a superior alternative to fixed maturity plans (FMPs):

Flexibility/better tax efficiency:

FMPs are for a fixed period of time, at the end of which the investment gets automatically redeemed. In case of any adverse changes in tax laws, one cannot extend the holding period. Since the mediumterm accrual funds are open ended, one can always take advantage by postponing the redemption in line with the changes in the tax laws. For example, investments in oneyear FMPs today will mature in August next year and will thus attract indexation. However, if the new Direct Taxes Code (DTC) gets implemented from next year, all the one year FMPs (growth option) maturing next year will deliver taxable returns, since the DTC is expected to change the definition of 'long term' from one year to one 'financial year'.

Liquidity:

Open-ended debt funds allow you to provide for any emergency, or take advantage of any investment opportunity that comes across, since redemptions in these funds are possible any time with the pay out in your bank account being realised a day after the redemption request is accepted. But here some exit loads may apply, which normally kick in if you exit within a year of your investment. Whereas, in an FMP your money gets locked-in for a fixed period and exit is almost impossible.

Regular or systematic investment:

You can invest in accrual funds whatever surplus amount you have in these funds, which could either be a lump sum investment or systematically every month (like bank recurring deposits but with better tax efficiency and ease of transaction).

Regular income:

In case one needs regular income, there is always an option of systematic withdrawal (the most tax-efficient way of taking out income from debt funds) in these schemes.

Capital appreciation:

In openended debt funds like these, fund managers generate some additional returns by periodically realigning the portfolio in line with the interest rate in the economy. Similar additional returns are not available in FMPs.

For all practical purposes, these schemes work like FMPs only. The idea behind these schemes is to maintain the positive features of an FMP, and eliminate the negative features. 

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