What are income funds? Detailed guideline & analysis of investing in income funds in India
Income funds attempt to generate consistent and regular returns for an investor by investing in government securities, debt instruments, high dividend generating stocks.
What is an income mutual fund?
Income funds belong to the category of debt mutual funds that focuses on providing a regular source of return to the investor.
These funds invest in a mixture of corporate bonds, money market instruments, and certificate of deposit. The returns under income funds depend on the market conditions and the performance of the fund.
Income funds attempt to deliver consistent returns through generating interest income by holding the instrument until maturity. Income funds are highly liquid and offer greater flexibility of redemption and withdrawal.
What is a fixed income fund?
Fixed income funds aim to provide an investor with returns at fixed intervals. This is more suitable for a risk-averse person who is looking for a steady source of income and not capital appreciation.
These funds are highly liquid in nature but do not offer growth opportunities like equity mutual funds. These funds consist of money market funds, debt funds, exchange traded funds (ETFs), fixed deposits schemes and certificate of deposit.
Below are a few fixed income generating instruments
Debt funds invest the funds in low-risk instruments such as government & corporate bonds and aims to offer stable returns.
The money market is a market for short-term financial assets that can be converted into money at a minimum cost.
Funds are invested in steady-income instruments such as treasury bills, commercial paper, certificate of deposit, etc. It is suitable for an investment horizon of up to 90 days
ETFs are index funds listed on the stock exchange. The units of ETFs can be bought and sold through a registered broker of the stock exchange, just like shares.
How do income funds work?
The Net Asset Value of an income fund is calculated up to 4 decimal places and the fund attempts to delivering returns in case of fluctuating interest rate scenarios. This can be done in either of the below 2 ways
- Generating interest income by holding the instruments until maturity
- Selling the instrument in the debt market in case of rising interest
The main objective of the fund manager is to deliver higher returns by allocating funds towards debt and money market instruments. This is dependent on the interest rate risk and the investment grade of the selected instruments.
Benefits of investing in income funds
- Income funds offer higher liquidity and the money invested can be easily withdrawn at any point in time.
- These are actively managed by the fund managers who take advantage of the changes in the interest rate to offer better returns.
- Income funds are considered better than fixed deposits both in terms of liquidity and returns for a short-term period. Compared to fixed deposit which has a fixed lock-in period, income funds enable the investor to have a flexible cash flow.
- The tax rate applicable to income funds is the same as applicable to the debt funds. Hence short-term capital gains are taxed as per the applicable slab rates whereas long-term capital gains are taxed at 20% with indexation benefits.
Things to consider before investing in income funds
Income funds are highly influenced by interest rate & credit risk. A change in the interest rate may lead to the change in the value of the bond price which will have an impact on the fund value.
Furthermore, there is always a risk of default on repayments as promised by the bond issuer which in turn will also affect the returns from the fund.
Fund managers take advantage of the interest rate volatility in the market to generate returns for investors. Income funds can offer better returns in case of a falling interest rate scenario.
These funds have offered better returns than a traditional investment in a fixed deposit. However, it is to be noted that there are no guaranteed returns in income funds.
As in the case with all other categories of funds, income funds also charge a fee to manage an investor’s funds. This is known as the expense ratio.
For example, if an investor has invested Rs. 10,000 in a fund that has an expense ratio of 2%, then he needs to pay Rs. 200 to the fund house to manage his fund.
The expense ratio is not fixed and different fund houses have different rates.
Generally one should have an investment horizon above 3 years to actually benefit from these funds. The fund managers take advantage of the interest rates to offer better returns but this requires proper skills to manage.
One should consider this mode of investment as an alternative to fixed deposit and is suitable for investors who are willing to take a moderate level of risk.
History of the fund house
As a general practice, people tend to choose the fund offering the highest returns. Apart from examining the expense ratio it is also important to do background research on the fund house.
This includes the history of the fund managers, the time period for which the fund house has been in operation, etc.
The tax rate applicable to income funds is the same as applicable to the debt funds. Hence if an investor is in the 20% and above slab rates, then long-term capital gains are taxed at 20%. However, indexation benefit is allowed in such a case.