What are Income Funds?

Key Highlights

• Income funds aim to generate regular income through assets like bonds, government securities, and dividend-paying stocks.

• Types of income funds include bond funds, equity income funds, money market funds, and real estate investment trusts (REITs).

Understanding Income funds

An income fund is a type of debt mutual fund. It generally invests in long-term debt instruments like bonds, government securities, debentures, certificates of deposit, etc. In general, there are two types of income funds. According to SEBI's mutual fund classification, the two debt funds listed below are income funds:

• Medium to Long Duration Funds: They are open-ended debt funds that allocate their investments across the money market and debt instruments. The duration is usually four to seven years.

• Long Duration Fund: They are open-ended debt funds that invest in money market and debt securities for over seven years.

Features of an Income Fund

After learning about income funds meaning let's look at their features. The following are some critical characteristics of income mutual funds in India:

1. Expense Ratio The expense ratio is the proportion of the scheme's total assets that the fund house charges as a fee for providing fund management services. The expense ratio upper limit for income funds set by SEBI is 2.25%. An income mutual fund offers low returns because it is a debt fund. As a result, investing in a fund with a high expense ratio may directly affect your profits. So, you should always look for funds with a low expense ratio.

2. Risks

Since an income fund is a debt fund, it is subject to interest rate and credit risk.

• Credit risk: It refers to the possibility that the issuer may fail to clear principal amounts and interests on time.

• Interest rate risk: It is the possibility that interest rate changes will affect the securities held by the fund.

To increase returns, an income fund manager may also invest in assets with lower credit quality ratings. This may raise the overall risk of a portfolio.

3. Returns:

If interest rates decline, income fund returns can vary from 7 to 9 percent. They use interest rate volatility to their advantage to achieve their investment objectives.

How do Income Funds Work?

An income fund's net asset value is determined up to four decimal places. It aims to provide returns when interest rates change. The following are the two methods to do this.

• Retaining the instruments till maturity to earn interest

• If the interest rates rise, sell the instrument in the debt market

The fund manager's primary goal is to increase returns by distributing assets across debt and money market securities. The investment grade of the chosen assets and the interest rate risk will determine this.

Types of Income Funds

What the fund is precisely investing in is the main point of distinction when it comes to the divergence of income funds. Among the income fund kinds are:

1. Bond Funds: Bond funds are a particular kind of income fund that focuses on investments in corporate and government bonds. Government bonds are appealing to investors because they are essentially risk-free. Moreover, they are a good option for those seeking a safe investment.

These bonds have lower dividend yields than corporate bonds because of the low risk. On the other hand, investors like corporate bonds because they offer higher yields due to the high-risk factor.

2. Equity Income Funds: An income fund invests in dividend-paying stocks. Investors who wish to earn monthly income from their dividend-paying portfolio are the target audience.

3. Money Market Funds: These are income funds that invest in certificates of deposit (CDs), commercial papers, and short-term treasury bills. They are also known as a money market fund. Money market funds provide investors a relatively safe investment alternative because of their lower interest rates.

4. Real Estate Investment Trusts (REITs): Owning properties like homes, hotels, retail stores, and commercial office buildings is a real estate investment trust (REIT). Getting the benefits of real estate ownership without actually owning and managing the property is the major benefit of a REIT income fund.

Benefits of Investing in Income Funds

The following are the advantages of investing in income funds.

• More returns than FDs: In the long run, income funds often give more returns than fixed deposits (FDs). They try to get higher returns by capitalising on fluctuations in interest rates. FDs carry very low risk. Whereas income funds have interest rates and credit risk.

• High liquidity: Contrary to FDs, income funds have no lock-in period. So, they let investors withdraw their money at any time. However, redemptions between one to three years may be subject to exit loads.

• Tax Benefits: Income funds may offer tax benefits, especially for investors in higher income tax brackets. Interest on fixed deposits is taxed according to the investor's income tax bracket. However, long-term capital gains (holding time longer than three years) on debt funds are subject to indexation.

Disadvantages of Income Funds

As there are several investment options, income funds might not be the first selection for investors. The following are some drawbacks of income funds, as compared to other financial instruments:

• Risk Assumption: Many people believe that income funds are entirely risk-free. However, this isn't true. When choosing an income fund, it's important to research properly. This is because some income funds can have a certain amount of risk. Equity income funds are an example of this.

• Evaluation of Performance: Income funds typically lack the capacity to evaluate performance in an efficient manner. The realised return, particularly in the case of dividends, may outweigh the actual financial benefit.

Taxation of Income Funds

Mutual fund dividends and capital gains have different taxation rules. When investors get dividends from a debt fund, they are not subject to taxes. However, the fund house must pay a dividend distribution tax to the government directly before paying the dividends. This is added to the fund's expense ratio. The returns are taxable as capital gains of investors.

The tax treatment of capital gains depends on the duration of ownership of the debt fund units. If debt fund units are held less than three years after the allotment date, earnings are considered short-term capital gains. This is applicable if you redeem or transfer them to another scheme. The taxation of short-term gains is based on the income tax bracket. They are added as annual income in the "income from other sources" section of the income tax returns (ITR) form.

Long-term capital gains tax is applicable if mutual fund units are held for more than three years after the allocation date. For debt funds, long-term capital gains are subject to a 20% tax with indexation.

Conclusion

Income funds are financial instruments that generate income regularly. They prioritise monthly income over capital appreciation. They usually invest in bonds, government securities, debentures, and dividend-paying stocks. Income funds offer higher returns than fixed deposits. Moreover, they are liquid and also provide tax benefits. However, they also have some risks. Interest rate fluctuations and credit risk are the major ones. So, research thoroughly and consider the potential drawbacks associated with a fund before investing.