Income Fund

People who invest in mutual funds have different investment goals and risk appetites. While some are prepared to take risks and prefer to invest in funds that offer high capital appreciation, others will want a steady income stream and less risky avenues to achieve their goals. Cautious investors who want a steady income stream prefer to put their money in an income fund.

There are two ways in which investors can get steady income – through dividend paying stocks or through interest rates. Generally, in India, income funds are debt funds that invest in either government bonds or highly rated government paper. The emphasis is on capital protection rather than appreciation, so fund managers tend to err on the side of caution while investing. For example, they will only put their money in government securities or corporate debt with very high credit rating.

Another kind of debt fund that may have a similar income earning objective is the balanced fund, which invests in a mix of equity and debt, with the scales tilted in favour of debt. The equity component of the fund will ensure higher returns, while the debt part will focus on earning a lower but steady return. To ensure regular income, investors must see that balanced funds have a right mix of equity and debt – the preferred ratio would be 60 per cent debt and 40 per cent equity. A variation is the monthly income plan (MIP), which invests a small portion in equity (say 10-20 per cent) and the rest in debt.

Income funds invest in a variety of fixed income instruments like corporate bond, debentures, commercial paper, certificates of deposit, treasury bills and so on.

Features of an income fund

• Low risk: One of the main features of this kind of fund is the low level of risk. Since fund managers focus more on capital protection, investments are made in either government bonds or corporate debt with high credit ratings.

• High liquidity: Funds like these have much better liquidity than many fixed income instruments like for example Public Provident Fund (PPF), which has a lock-in period of 15 years! Bank fixed deposits are more liquid these days since you can break them at a moment’s notice, but you get a lower interest rate if you withdraw prematurely.

• Diversification: Another benefit of an income fund is that it invests in a number of fixed income instruments so the risk is spread out. Many of these investment avenues are not open to retail investors. For example, you just cannot purchase government bonds on your own; only institutional investors are allowed to purchase them on a wholesale basis.

• Better returns: An income fund is in a better position to earn higher returns. This is because these funds buy debt in large quantities, and are hence able to negotiate better interest rates, especially from corporate borrowers.

• Tax benefit: Debt funds are taxed only when they are redeemed unlike comparable instruments like bank fixed deposits whose interest earnings are added to your income every year and taxed accordingly. If you hold an income fund for over three years, you will have to pay a tax of 20 per cent with indexation. So you will end up saving some money on tax, especially if you are in the highest tax bracket.

• Risks: While debt funds involve less risk than equity fund, they are by no means risk free. There are two kinds of risks that debt funds face. One is the risk of default, in which case the loss will have to be borne by the fund, leading to lower NAVs. Of course, this risk is considerably mitigated by investing in debt with high credit rating. Another risk is of a change in interest rates. When interest rates rise, the yields of bonds in the income fund’s portfolio will fall, and thus NAVs will also drop. On the contrary, when interest rates go down, yields will increase, leading to higher NAVs. So the returns you make will depend on the interest rate scenario. In a rising interest rate scenario, it might be better to look at other options like bank fixed deposits.

How to select the right fund

• Compare returns: You can check an income fund’s returns over several time periods to find out how much it is making. Choose one that has shown consistent returns. AngelBEE’s mutual fund investment app will help you find the best fund.

• Expense ratio: Generally, since returns tend to be on the lower side for income funds, expense ratios too are commensurately low. Nevertheless, it’s best to shop around for a fund that has a low expense ratio, since a small difference can affect the kind of returns you can make.

• Fund house: It’s always better to choose a fund house that has a solid reputation and has been in business for a few years.

• Fund manager: A good fund manager can help you make above average returns. Information on fund managers is readily available, so make sure you check that out.

• AUM size: It’s better to invest in a fund that has a sizeable corpus. There are several reasons why this is beneficial. For one, the risk of the fund being exposed too much to a single borrower is low. Two, a bigger fund is able to negotiate better terms from corporate borrowers.

• Time horizon: Income funds are suited for investors with a longer time horizon, say, one to five years. If you want to park your money for shorter periods, you would do better to invest in liquid funds or short term debt funds. Remember that you get indexation benefit if you stay invested in a debt fund for over three years.

• Financial goals: Your financial goals must be steady income and less risk. Income funds are ideal for, say, retired people who want a regular income. It’s also pretty useful for those who want to save up money to meet long-term goals like children’s higher education or to accumulate enough money for a down payment on a house.