There are several investment schemes to cater to various categories of investors. However, such a wide variety  tends to be confusing for individuals. One such popular investment option includes income funds. 

Successful investing demands a well-researched and thorough approach to avoid potential pitfalls. This is why individuals willing to opt for this option must first have detailed knowledge on how they work and things to consider before allocating funds. 

Income funds fall under the category of debt mutual funds. Accordingly, such schemes invest in fixed-income securities, which include bonds, debentures, money market market instruments, and more.   The main objective of an income fund is to provide investors with regular income as well as stability. 

Since the portfolio of these funds does not comprise equity and equity-related instruments, their performance is not impacted by price fluctuations in the stock market. Accordingly, they carry lower financial risk than equity funds. That said, there is limited scope of capital appreciation owing to the lack of equity exposure. 

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A fund manager invests in fixed income instruments having established financial track records and high credit ratings. Such organisations have lesser default risk in repayment of interest and capital.

An income fund’s net asset value (NAV) is impacted owing to the changing interest rates in the economy. In a falling interest rate regime, the NAV of an income fund is likely to increase, and vice versa. The fund manager actively manages the portfolio to provide maximum returns irrespective of whether interest rates in the market are increasing or decreasing. 

Income funds earn income on their investment in fixed income securities via the following two ways:

• Interest payments: These funds receive interest payments if they hold the debt securities until the end of their maturity period. 
• Price appreciation: In case interest rates in the market fall, the price of the fixed income securities rises. Fund managers take advantage of this scenario and offload the holdings at the increased price to make financial gains.

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The various income fund benefits are illustrated as follows -

• Higher returns than bank deposits: Though they carry interest rate risk and credit risk, income funds accumulate greater returns within a short time compared to savings and fixed deposits.

• High liquidity: Income funds do not come with a lock-in period. Investors can choose to redeem the units at their convenience, 

• Low reinvestment risk: Reinvestment of funds in different interest rate cycles usually lead to higher returns. Thus, income funds are associated with low investment risk.

• Tax benefits: Individuals earning long term capital gains from their investments in income funds are eligible for indexation benefit. 

• Stable income: Such mutual fund schemes have the potential to generate regular income and offer stability at the same time. This is because the portfolio of income funds comprise fixed income securities only. 

Income funds are ideal for risk-averse investors who are seeking stable and regular income. For example, retired individuals requiring funds for meeting their daily expenditures might prefer income funds to other fund types. 

Furthermore, conservative investors willing to earn higher returns compared to their conventional havens, such as savings and fixed deposits  might also consider investing in income funds.

Even individuals with greater risk appetites who prefer investing through equity or equity-oriented schemes can look forward to allocating a part of savings to income funds for diversification purposes.

If an individual decides to invest in income funds, he/she has to choose the type of plan first. In that regard, there are two available  options: 

• Direct plan: These mutual fund schemes are offered by asset management companies directly. Individuals can choose to invest in a direct plan through the fund house’s official website. Alternatively, they can allocate their funds via certain online platforms/mobile-based applications. 
• Regular plan: When investors invest in a scheme via a broker/distributor, they are opting for a regular plan. In comparison to direct plans, regular plans have a higher expense ratio as the fund houses need to pay commission to the intermediary. Accordingly, they report a lower NAV. However, investors might still consider investing via a regular plan for advisory services. 

Note that a direct plan has a lower expense ratio in comparison to a regular plan as the fund house does not have to pay any distribution fee to brokers/distributors. Moreover, for this reason, the NAV is higher in case of the former.

After deciding which plan to opt for, investors need to decide the investment mode. They can choose to invest via a systematic investment plan (SIP), and allocate a fixed sum at regular intervals (monthly, quarterly, etc.) to a scheme. Alternatively, they might invest the entire amount available with them by opting for the lump sum mode. 

Individuals willing to invest in income funds should consider the below-mentioned factors:

Risk

Income funds carry both interest rate risk and credit risk.

• Interest Rate Risk: Price of debt securities and the interest rates of the market have an inverse relationship. In case interest rate rises, price of the securities held by the fund would decrease. Accordingly, the net asset value of the scheme would fall, leading to losses.
• Credit Risk: This refers to the chances that the issuer of the fixed income securities might default on their payment upon completion of the maturity period. Sometimes fund managers may allocate the invest corpus to financial instruments bearing a lower credit rating for earning higher returns. This increases the financial risk associated with the investment.

Returns

Income funds can be an excellent way of making greater returns by taking advantage of the volatile interest rates. However, given that there are no guaranteed returns in income funds, they should be prepared to bear the additional risk. 

When comparing the top income funds, it is vital for individuals to consider the past returns of the schemes. This would give investors an idea regarding the consistency of the funds in terms of performance.

Cost

Income funds charge an amount as a fee for managing the fund. This fee is imposed annually, and is termed as an expense ratio. The higher the expense ratio, the more impact it will have on investors’ returns. Hence, it is vital to compare the expense ratio of different income funds before opting for a scheme. 

Investment Horizon

Before investing in an income fund, individuals must make sure to decide their investment time horizon after taking into account their financial goals.

Taxation

The applicable tax rate for income funds is the same as that for debt funds. When investors redeem their units within 3 years, they earn short term capital gains (STCG). The tax liability on such returns depends on the income tax slab rate of the individual.  That said, upon redeeming the units post 3 years, a flat tax rate of 20% is imposed on such gains. The realised returns attract 20% tax after indexation.

History of a Fund House

Generally, individuals choose a fund that delivers the highest returns. That said, besides examining the expense ratio, and past performance, it is imperative to conduct background research on the fund house. 

This includes the duration for which a fund house has been operating, the history of fund managers, etc.

Financial Goals

Income funds invest in fixed income securities with an aim to generate consistent and regular income. Accordingly, these funds are a suitable option for supplementing an investor’s current income. Before investing, individuals must make sure that the objective of the fund is in line with their financial goals.

Individuals must keep in mind the above mentioned aspects related to income funds. In case they choose to invest in these schemes, it is crucial to weigh the pros and cons and decide whether they are a suitable option.