Chemical wood cellulose fiber modification is performed with the purpose to improve compatibility and induce nanofibrillation of fibers during melt compounding of thermoplastic biocomposites. Compounding of well-dispersed cellulose nanocomposites based on biodegradable polymers is challenging and commonly requires separate processes for wood fiber fibrillation into cellulose nanofibrils (CNF), followed by compounding. Here, nanostructured biocomposites based on poly(caprolactone) (PCL) and holocellulose wood fibers (HC) were melt compounded in a single step. Prior to compounding, PCL was grafted from the HC fibers by ring-opening polymerization (ROP) of εCL with three different polymer graft lengths. The grafting was performed by two different methods: the commonly used bulk method and a new approach using acetic acid (AcOH) as the reaction solvent to swell the fiber structure during grafting. Remarkably, AcOH as a swelling solvent resulted in high density of grafts inside the nanostructure and throughout the volume of the HC wood cellulose fibers. As a consequence, more pronounced defibrillation of fibers into CNF during compounding as well as more uniform CNF dispersion in the thermoplastic PCL matrix was observed. In contrast, fibers grafted under bulk conditions showed little grafting and weak reinforcement effects. The Young’s modulus and strength of the PCL were improved by almost 60% with the addition of only 5 wt % fibers, and the toughness was improved by 67%. The results show a close connection between the graft structure and final material properties.