‘Income’ amidst falling interest rates

Income funds can gain a substantial size of one’s portfolio for longer term in the current falling interest rate scenario but investment depends on the investor's risk appetite, investment horizon and other investment options.

At a time when most of the investment products have given negative returns, investors are left with fewer options to park their hard-earned money into. However, falling interest rates can be taken advantage of by investing in income funds, as these funds tend to perform well when the interest rates are falling.

What are Income funds?

Income funds are debt funds that generally invest in fixed income securities, such as bonds, corporate debentures, government securities and short-term instruments, such as commercial papers.

Along with stability of capital, such schemes emphasize on providing regular income, which comes from coupon payments. The instruments in which the fund invests generate fixed returns and as such the fund can provide income to investors.

Typically, these funds bet on interest rate fluctuations, their performance being in inverse proportion to the interest rates. Thus, when there is a drop in interest rates, the yield from such schemes increases and vice-versa. At present, with inflationary pressures cooling off, the interest rates are expected to move southwards. This can be a good opportunity for investors to earn returns by allocating a portion of their portfolio towards income funds.

Depending upon the interest rate movement anticipated, the fund manager can invest in bonds with different maturities which could range from anything between a year to fifteen years.

Advantages

Higher returns through flexible maturity

Owing to their flexible maturity profile, income funds gain an upper hand over conventional debt products, like bonds and fixed deposits. Whenever there are lesser chances of a rise in interest rates, fund managers prefer to extend the duration of the fund’s portfolio, which increases the return of the portfolio. As against this, fixed deposits do not have any such flexibility.

Tax gain

Income funds offer an additional benefit of tax advantage, making them a good alternative to fixed deposits. This is because interest earned on fixed deposits is not exempted from tax..

Charges for premature withdrawal

Most of the banks charge a fee for premature withdrawal of fixed deposits, which is not true in the case of income funds.

Tax Implications

Debt funds, except liquid and money market funds, pay a Dividend Distribution Tax of 14.16 per cent (When income is distributed to Individuals and HUFs). In the long term, they have the benefit of Indexation, which gives the option of paying taxes – 20 per cent with indexation benefits and 10 per cent without indexation benefits (whichever is lower).

Risk factor

As compared to equity funds, these funds are less risky. However, these funds are subject to fluctuations in interest rates. Such risks are high over the short term; hence, investment in income funds should ideally be for a slightly longer duration – at least a year.

Another risk faced by income funds is the default or credit risk. It refers to the possibility that the issuer of the fixed income security may default, that is, the issuer may be unable to make timely payments of the principal and interest amounts due to some financial crisis arising at the time of payment. While there is no default risk on government securities, the same does not hold true for corporate debt, where there exists a possibility of default. Fund managers, thus, strive to allocate most of their corpus to high-rated debt, whose issuers have strong creditworthiness.

Conclusion

Over the long term, income funds tend to generate better returns than short-term funds. Investments in income funds should be done at the peak of the interest rate cycle. Systematic investment plans are a good way of capturing growth instead of committing an upfront principal. This can be a good alternative to fixed deposit as the product offers an additional benefit of tax advantage too.

Such schemes can be a part of the portfolio of retired individuals as well as young investors.