Accrual is the accumulation of interest from fixed income securities that a portfolio holds. Liquid funds, FMPs are example of accrual funds.
Accrual funds do not focus on rise or fall in security prices due to interest rate changes. The accrual fund looks to minimise interest rate risk by either shortening maturity of its fixed income portfolio or by investing in high yield securities that have lower sensitivity to interest rate movements. Accrual funds largely hold securities to maturity. Accrual funds carry low interest rate risk in normal markets but can carry credit risk if invested in high yield corporate bonds.
Consider that investor has 91-day T-bill in fixed income portfolio.
Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the face value at maturity. Consider 91-day Treasury bill of face value Rs.100 issued at Rs 97 at a discount of Rs 3 at yield of 12.40% and would be redeemed at the face value of Rs. 100.Rs 3 here can be considered as accrual income. The return to the investors is the difference between the maturity value or the face value and the issue price.
Consider a 3-year AAA corporate bond that has coupon of 9.30% payable annually. Accrual fund holds this corporate bond in its portfolio.
Every year, the fund earns coupon interest of Rs 9.3 on every Rs 100 of investment in this bond, which is accrual income. The bond is rated AAA and hence carries low credit risk. Interest rate risk is minimised by the fact that for a 100bps rise in yield of the 9.30% 3-year maturity AAA bond, there will be a capital loss of 1.8% in one year. The capital loss is more than compensated by high accrual of 9.3% on the bond every year.
Accrual income has less volatility compared to capital appreciation. It provides stability to fixed income portfolio in all interest rate environments (Falling, stable and rising interest rate) and during high volatile market phases.
Accrual income can be received even by low rated high yield short maturity bonds but investors need to look at liquidity of those bonds and credit profile of issuer.