A Comprehensive Guide Income Funds have evolved into a preferred investment tool in India. Over the years, several types of mutual fund schemes have been launched to attract different types of investors. In fact, all these different types of schemes have led to some amount of confusion in the investor’s mind. Successful investing requires a thorough and well-researched approach to avoid potential pitfalls.
This starts with understanding the different types of schemes available to you. Here, we will explore Income Funds and talk about the different types of income funds in India along with their benefits and a lot more.
What are Income Funds?
?Income Funds are a type of debt funds. Invest in debt instruments like debentures, corporate bonds, government securities, etc. for a longer duration. The Securities and Exchange Board of India (SEBI) classifies Income Funds as those debt funds whose Macaulay Duration is 4 years and more.
Therefore, there are two types of debt funds which fall into the category of Income Mutual Funds:
Medium to Long Duration Fund – Macaulay Duration = Between four and seven years
Long Duration Fund – Macaulay Duration = More than seven years
How do Income Mutual Funds work?
The fund manager of an income fund endeavors to deliver good returns regardless of the interest rate regime. This means that Income funds try to offer returns whether the interest rates are rising or falling. This is done by active management of the investment portfolio.
The two broad strategies followed by fund managers are:
Generating interest income –
which is achieved when the fund holds the debt instruments until maturity
Earning gains –
which is achieved by selling the debt instruments in the market if their price increases
Usually, these funds prefer debt instruments with higher security (or instruments with a higher quality rating) and a lower interest rate risk. If you look at the historical performance of income funds, you will find that they tend to outperform the returns offered by traditional bank deposits while offering more flexibility and liquidity.
Who should invest in an Income Mutual Fund?
By the virtue of its definition, an income fund is best-suited for an investor with moderate risk tolerance and an investment objective of earning regular returns. These are a good option for conservative investors looking to explore mutual funds in a low-risk zone.
Features of an Income Fund
Here are some salient features of Income Mutual Funds in India:
The expense ratio is the percentage of the scheme’s total assets which the fund house levies as a fee for offering fund management services. SEBI has created an upper limit for the expense ratio for income funds at 2.25%. Being a debt fund, the returns from an Income Mutual Fund is not very high. Hence, a fund with a high expense ratio can have a direct impact on your earnings. You must look for a scheme with a lower expense ratio.
Risks and Returns
Being a type of debt fund, an income fund carries both credit risk and interest rate risk.
Credit Risk – this is the default risk of the issuer not repaying the principal and interest.
Interest Rate Risk – this is the risk due to the impact of the change in interest rates on the value of the fund’s securities.
Additionally, the fund manager of an income fund may also invest in securities with a lower credit quality rating for generating better returns. This can increase the overall risk of the portfolio.
Income funds returns can be in the range of 7-9% in a falling interest rate regime. These funds take advantage of the volatility in interest rates to meet their investment objectives.
Invest according to your Investment Plan
Income funds are a great option for investors looking to park their funds in a long-term fixed deposit. They are designed to help you enhance your current income by investing in debt securities which can generate high income. Ideally, you should try and invest in these funds when the interest rates are falling and exit when they start rising.
In the case of Income Mutual Funds, the taxation rules are as follows:
Capital Gains Tax
Capital Gains Tax is levied according to the holding period which is the period for which you hold the units of the scheme – or the period between purchase and redemption of the units.
If the holding period is up to three years, then the capital gains earned by you are called short-term capital gains or STCG. STCG is added to your taxable income and taxed as per the applicable income tax slab.
If the holding period is more than three years, then the capital gains earned by you are called long-term capital gains or LTCG. LTCG is taxed at 20% with indexation benefits.
What are the benefits of investing in Income Mutual Funds?
The primary benefits of investing in an Income Fund are as follows:
An Alternative to Fixed Deposits – Income funds tend to generate returns that are better than those offered by fixed deposits. However, you must remember that income funds carry credit risk as well as interest rate risk, while fixed deposits are considered risk-free.
High Liquidity – While fixed deposits charge a penalty for premature withdrawal, income funds have no such lock-in periods. However, some schemes might levy an exit load for early withdrawal. Ensure that you check the charges before buying.
Tax benefits – If you fall in the highest income tax bracket of 30%, then investing in income funds can offer you tax benefits. LTCG is taxed at 20% with indexation while the interest that you would earn on a fixed deposit will be taxed as per your tax slab.
In conclusion, Income Funds are an attractive investment option for individuals with moderate risk tolerance who seek regular returns. They serve as an alternative to fixed deposits, potentially providing better returns. They offer high liquidity, and some investors may benefit from tax advantages, particularly those in higher tax brackets.
However, it's crucial to recognize that these funds carry risks, including credit risk and interest rate risk. To make well-informed investment decisions, investors should carefully assess these factors and consider their financial goals and risk appetite. Consulting with a financial advisor is advisable when exploring mutual fund investments.