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Income Funds – How do they work?

  • Rudri Rawell
  • Jan 12 2022
  • 7 minutes
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Mutual fund investors often have different investment goals and also varying risk appetites. While some may be willing to take on higher risks and prefer mutual funds that offer high capital appreciation, many investors prefer a steady income source and invest in less risky options for achieving their goals. Cautious investors looking for a steady income source tend to prefer income funds. So, what are income funds? How do they work?

Here, we will explore the concept of Income funds and share details such as their benefits, risk factors, etc for new investors.

What is an Income Fund?

An income fund is a form of debt mutual fund that aims to generate returns through investments in relatively long-term debt instruments such as government securities, corporate bonds, debentures, certificates of deposit, etc. These also invest in high dividend generating stocks to provide a source of regular income to investors. 

There are two forms of mutual funds that can fall within the income fund category. As per SEBI, the below-mentioned two debt funds can come under income funds:

  1. Medium to Long Duration Fund: This is an open-ended debt fund that invests in debt and money market instruments. The main objective is to maintain the Macaulay Duration of the fund between 4-7 years. For new investors, Macaulay duration is the time taken by an investor to get back the invested value in the bond through periodic interest combined with principal repayments.
  2. Long Duration Fund: This open-ended debt scheme invests in debt and money market instruments with an objective to maintain Macaulay Duration for more than 7 years.

How do Income Funds work?

The NAV or Net Asset Value of an income fund is generally calculated up to 4 decimal places. Income funds attempt to deliver returns to investors, even in fluctuating interest rate scenarios. Here are the two commonly used ways to achieve this:

  • Generate interest income by staying invested in the instruments until maturity
  • Sell the instrument in the debt market during rising interest rate scenarios

The fund managers of income funds aim to deliver higher returns through allocation of funds in debt and money market instruments. However, this can have interest rate risk and performance of the fund also depends on the investment grade of the instruments chosen.

Benefits of investing in Income Funds

Some of the noteworthy benefits of income funds are as follows:

  • Better returns than Bank FDs: Income funds often generate returns that are better than bank fixed deposits, especially in the long term. This is primarily done by making the most of interest rate volatility. However, income funds are exposed to interest rate risk and credit risk. On the other hand, FDs usually have negligible or zero risk factors.
  • Easy liquidity: Income funds do not come with a lock-in period, and investors can withdraw their investment at any time. This is not the case with bank FDs, since they often have lock-in periods, especially the tax-saving variants. However, in the case of income funds, exit loads could be imposed on investors looking to redeem their investment within 1-3 years.
  • Tax efficiency: Income funds are more tax efficient as compared to fixed deposits. This is especially true for those investors whose income falls within the income tax bracket of 30%. Long-term capital gains from debt funds are taxed at 20% with indexation. Comparatively, interest on fixed deposits is taxed as per the income tax slab of the investor.

Who should invest in Income Mutual Funds?

Income funds are ideal for investors who have a moderate risk tolerance and have an objective of earning regular returns through their investment. Conservative investors who want to explore mutual funds with a low-risk appetite can consider investing in income mutual funds.

Things to consider before investing in Income Funds

Some of the elements that investors must consider while investing in income funds are:

  • Risk – Due to the nature of investments, Income funds are exposed to interest rate risk & also credit risk. Interest rate changes could lead to a change in bond prices, and this can have an impact on the fund value. Additionally, a risk of default on repayments by the bond issuer can also affect the returns from an income fund.
  • Return – Fund managers of income funds often take advantage of the interest rate fluctuations to generate better returns for investors. Income funds may generate better returns during falling interest rate scenarios. These funds can generate higher returns as compared to traditional investment forms like bank fixed deposits. However, these do not guarantee returns as against fixed deposits which can guarantee returns.
  • Cost – Similar to other mutual funds, income funds also charge fees for managing an investor’s funds. This is called the expense ratio. For instance, if an investor invests Rs. 10,000 in an income fund with an expense ratio of 2%, he/she has to pay Rs. 200 to the fund house towards managing the fund. The expense ratio could differ across fund houses and has an impact on the net returns generated by an investor.
  • Investment horizon – Investors must have an investment time horizon of more than 3 years to benefit from an investment in income funds. Fund managers can make the most of interest rate fluctuations to generate positive returns in the long run, provided they have the right level of expertise to do so.
  • Background of Fund house – Investors often choose funds that offer the highest returns. While looking at factors such as the expense ratio, it is important to perform a background research on the fund house. Looking up details such as, history of the fund managers, the period of existence of the fund house, etc is equally important.

Which are the top income funds in India?

Some of the top performing income funds in India are:

  • SBI Regular Savings Fund
  • Aditya Birla Sun Life Treasury Optimizer Fund
  • Franklin India Income Builder Fund
  • ICICI Prudential Banking & PSU Debt Fund
  • Axis Regular Savings Fund

Conclusion

Individuals nearing their retirement can consider investing in income funds, as these can provide steady income without involving a high level of risk. Depending on the fund manager and the fund house, income funds can generate positive returns in the long run. Therefore, investors must consider a time horizon of 3 years or more while investing in income funds.

FAQs on Income funds

  1. What is the goal of an income fund?
    An income fund aims to provide a steady stream of income to investors through investment in dividend-yielding stocks and debt instruments. These tend to focus on benefiting from interest rate movements in the long run.
  1. Are income funds safe?
    Income funds are safer as compared to equity mutual funds. This is because income funds focus on investment in debt instruments and carry low-to-medium risk levels.
  1. Can income funds lose money?
    Income funds are subject to interest rate risk and also credit risk. Therefore, depending on the fund manager’s expertise, income funds may or may not lose money. Investors must therefore be prepared to take on low to medium risk while investing in income funds.
  1. How to invest in income funds?
    Investors can download and launch the Finity app for a smooth investment process while investing in income funds. The app allows investors to select funds as per their investment objective and time horizon. It also involves a seamless KYC and registration process to easily begin investing.
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