Income funds are mutual funds or exchange-traded funds that generate a stream of income for investors instead of focusing on capital appreciation. These funds hold various government, municipal, and corporate debt securities, preferred stocks, money market instruments, and dividend stocks.
What are income funds?
As the name suggests, income funds generate earnings for the investors by investing in securities that pay out consistent interests or dividends. The fund managers of income funds manage the investment to deliver returns in rising and declining interest rate conditions. And, they do it by adopting any of the two methods,
- Generating interest income by holding the securities in the portfolio until maturity
- Gaining capital appreciation by selling securities in the debt market if the price of the security goes up
The fund managers target debt securities with higher returns and stability to ensure the portfolio generates returns in all market conditions. It is because share prices in the income bonds are unpredictable, rising when interest rates fall. So, the bonds included are of investment-grade or top credit rating to preserve initial capital.
Income funds come in a wide variety, primarily based on the underlying securities they invest in to generate income.
Money market funds
Money market funds invest in money market instruments like certificates of deposits, commercial papers, and short-term treasury bills. These funds generate safe returns by maintaining a low share price always. Although the returns are not assured, these instruments are traditionally the safest investments.
Bond funds
Bond funds, as the name suggests, invest in corporate and government bonds. Government bonds are the highest kind of bonds with no risk of default and therefore are a haven for investors during uncertain periods. However, these often offer the lowest interest rate compared to other types of money market instruments.
Compared to government bonds, corporate bonds carry additional risks that the issuer might default, and hence, these bonds are given various credit ratings. Corporate bonds funds are of two types – funds investing in investment-grade bonds and junk bond funds.
Equity income funds
Equity income funds invest in company stocks that pay out regular dividends. These funds create a secondary source of income for investors, generating predictable income. These funds are top-rated among investors looking to build a pension corpus from their investment to meet cash expenses.
Other income funds
Some income funds also invest in other investments like real estate trusts, preferred stocks, and the like.
Who should invest in income funds?
These schemes are suitable for investors who want to have a regular and stable income from their investments. These funds invest in money market instruments carrying the lowest risks of default.
Investors who want to create their own pension income use these schemes to park their investable corpus and create a source of regular earning from interest payouts.
Also, conservative investors prefer to invest in income funds to earn better returns than traditional savings.
Elements to consider as an investor
Risk
Income funds are for generating stable returns under different market conditions. The fund managers invest in assets of varying maturity dates and investment risks to safeguard the capital. However, these bonds are susceptible to interest rate risks. The rise in the interest rate would cause the underlying asset prices to fall. Besides, there is always a risk that the issuer might default in making principal and interest payments.
Returns
During uncertain periods, income funds are a great way to earn higher returns. Income funds can generate 7-9 percent returns, higher than other fixed income-generating investment options. However, these returns are not guaranteed and hence riskier than bank’s fixed deposits.
Cost
Income funds charge investors fees to manage their investment or expense ratio. SEBI has fixed the upper limit for asset management companies to charge expense ratio at 2.25 percent. Hence, staying invested for an extended period will help to recover the cost paid through charges.
Investment period
Investors with an investment horizon of 1 to 3 years may consider these schemes to park excess investable funds.
Short-term investors, however, need to time entry and exit carefully to receive maximum benefits. The rule of thumb suggests entering the market when interest rates are low and exiting when rising. Long-term investors can also invest in income funds to earn better returns than fixed deposits.
Financial goals
Because of their characteristics as income generators for investors, these funds cater to a wide range of investors with various financial goals. Retiree investors can invest in income funds to generate a steady flow of cash besides their regular pension. Besides, you can plan a SIP, SWP, or STP with these schemes and even plan for short-term financial goals like funding EMI.
Taxation
The capital gains from the fund are taxed per capital gain tax rate, calculated depending on the investment tenure. Since these invest in debt instruments, the short term capital gain rates apply to an investment period of fewer than three years.
Long term capital gain tax applies at a rate of 20 percent with indexation, and 10 percent without indexation, above three years of investment.
Conclusion
Income funds help in portfolio diversification and improving its overall returns. Find the best income funds in the market based on your investment objectives to invest.
