Invest in Income Fund

How do Income Funds work?

The Net Assets Value of  Income fund is calculated up to 4 decimal points. Income funds attempt to deliver returns both in declining and rising interest rate scenarios by active management of the portfolio. They may follow either of the two strategies:

a.  Generate interest income by holding the instruments till maturity

b.  Manage gains by selling them in the debt market if the price of the instrument goes up high.

The fund manager aims to deliver higher returns which have higher stability by allocating towards debt and money market instruments which are investment grade and have relatively low levels of interest rate risk. Historically, income funds have found to generate higher returns than conventional bank fixed deposits. Unlike the lock-in period in an FD, income funds offer greater flexibility of redemption and withdrawal.

Who should Invest in Income Fund?

Income funds are best suited for those investors who wish to have regular and stable income. This type of fund carries less risk with respect to default. For example, a person retired from the job will need money for his day to day expenditure will prefer income fund in comparison to all other funds. Conservative investors who want to earn better returns than their conventional havens may think of income funds.

Things to consider as an Investor

a. Risk

Income funds are highly susceptible to interest rate risk and credit risk. A steady increase in interest rates may lead to a fall in the underlying bond prices which in turn would lead to falling in the fund value. Moreover, there’s always the risk of a bond issuer defaulting on making a promised payment which might affect fund returns. Additionally, in order to generate higher returns, the fund manager may invest in securities of lower credit rating thereby increasing the overall portfolio risk.

b. Returns

Income funds can be a great way to make higher returns by taking advantage of interest rate volatility. Especially, in the scenario of falling interest rates, income funds can deliver relatively higher returns in the range of say 7%-9%. Instead of investing your money in regular bank fixed deposits (FDs), you may think of income funds as an efficient alternative. However, be prepared to bear the additional risk as there are no guaranteed returns in income funds.

c. Cost

Income funds charge a fee to manage your money called an expense ratio. Till now SEBI had mandated the upper limit of expense ratio to be 2.25%. Considering the lower returns generated by income funds as compared to equity funds, a long-term holding period would help in recovering the money gone out by way of the expense ratio.

d. Investment Horizon

Investors who have an investment horizon of 1-3 years may consider income funds to invest their short-term surplus funds. You need to time your entry and exit properly to get the maximum out these funds. The ideal time to enter would be at lower interest rates and make an exit as the interest rates start rising. If you are planning to keep your funds in the long-term FDs, then income funds would be a better alternative.

e. Financial Goals

Income funds, as the name suggests, invest in high-income generating securities which are ideal to supplement your current income. Retirees may invest in income funds to get extra money apart from their regular pension. If you have a short-term goal of funding your EMI or planning for higher education, these funds can help you achieve these goals. These funds are very flexible as they provide options such as SIP, STP, and SWP.

f. Tax on Gains

When you invest in income funds, you earn capital gains which are taxable. The rate of taxation is based on how long you stay invested in an income fund called as the holding period. A capital gain made during a period of less than 3 years is known as a Short-term Capital Gain (STCG). A capital gain made over a period of 3 years or more is known as Long-term Capital Gains (LTCG).

STCG from income funds are also added to the investor’s income and taxed according to his income slab. LTCG from income fund is taxed at the rate of 20% after indexation and 10% without the benefit of indexation.