Income Funds are a kind of debt mutual fund that generates returns by investing in comparatively long-dated debt instruments such as government securities, corporate bonds, certificates of deposits, debentures and money market instruments. They primarily focus on earning a regular income for its investors rather than the growth of capital. Therefore, these funds invest in bonds and stocks that generally pay high dividends and interests. This article covers the various essentials one needs to know about Income Funds.
Working of Income Funds
Income funds work to deliver returns in both declining and increasing interest scenarios with the help of active management of the portfolio. These funds follow either of the two strategies.
- Manage gains, if the price of the instrument increases, by selling them off in the debt market.
- Generate an interest income by holding the instruments until maturity.
The fund manager works with the objective to deliver high returns and higher stability by allocating funds towards the debt and money market instruments as they have comparatively low levels of interest rate risk. It is generally true that income funds are found to generate high returns when compared to conventional fixed deposits in banks. Income funds provide great flexibility of withdrawal and redemption when compared to the lock-in period of a Fixed Deposit.
Income Fund Investors
Investors who seek regular and a stable income are best suited for income funds. Funds of these kinds carried very less risk with respect to default. To take a simple example, an investor retired from his everyday job would need money for his daily expenditures and would prefer to opt for income funds above all other funds. Other conservative investors may opt for income funds when they want to earn higher returns than their usual conventional havens.
Investor Check List
The following have to be researched by the investor in order to make a successful investment.
Income funds are highly prone to risks through interest rate and credit. A constant increase in the interest rates may result in a dip in the underlying bond prices thereby, lead to falling in the fund value. Moreover, there is always the risk of a particular bond issuer defaulting on a promised payment and in turn affecting the fund returns. Adding to this, the fund manager may invest in securities of lower credit in order to generate higher returns and thereby, increasing the overall portfolio risk.
In income funds, high returns may be obtained by taking advantage of the interest rate volatility. Income funds can deliver a relatively high return in the rage of 7% – 9% when the interest rates start falling. Investing in income funds is an efficient alternative when compared to investing in Fixed Deposits in regular banks. However, as there are no guaranteed returns in income funds, every investor must be prepared to face the additional risks.
For investors who have kept an investment horizon of 1-3 years, may consider these funds as viable to invest their short-term funds. An investor is required to time their entry and their exit correctly in order to make the most out of these funds. The most profitable time to enter would be when the interest rates are low and make an exit as the interest rates are increasing. Income funds are considered to be better alternatives if the investor plans on keeping their funds in long-term fixed deposits.
An amount called as an expense ratio is charges by Income funds in order to manage the investor’s funds. Currently, 2.25% is the upper limit of the expense ratio that has been officially mandated by SEBI. A long-term holding period would help the investor in recovering the money deducted as expense ratio when considering low returns generated by income funds when compared to equity funds.
Tax on Gains
When an individual invests in income funds then, they earn capital gains that are liable to tax. The rate of the tax liability is based on how long the investor stayed in an income fund called the holding period. Short-term Capital Gain (STCG) is a kind of capital gain that is made during the period of fewer than three years. On the other hand, Long-term Capital Gains (LTCG) is the kind of capital gains that is over a period of 3 years and more. In the case of STCG from income funds, it is added alone to the investor’s income and tax would be applied according to their tax slab. However, LTCG is taxed at a rate of 20% after indexation and 10% without including the benefit of indexation.
Income funds invest in higher-income generating securities that would be ideal to supplement the investor’s current income. The most prominent group are Retirees who may invest income funds to obtain extra money without including their regular pension. If an investor has a short-term goal such as funding their EMI or higher education, investing in these funds would help them reach their goals. They are very flexible as they offer options such as STP, SIP, and SWP.
Lock-in periods are not applicable to income funds, unlike some fixed deposits. This allows an investor to withdraw their investment at any given time. However, exit loads may be suitable for redemption within the period of 1-3 years in these funds.
Taxation of Income Funds
The capital gains and dividends generated on mutual funds are taxed in a different way. An investor is not liable to pay taxes for dividends he receives in the case of debt funds. However, the fund houses are liable to pay a dividend distribution tax to the government before the dividend reaches the investor. This tax would be included in the expense ratio of the fund. Although, capital gains are taxable in the hands of the investor who earns it.
Depending on how long the units of debt fund were held on to before the redemption or switch, capital gains is taxable either as long-term capital gains or short-term capital gains. The profits from debt fund are deemed as short-term capital gains if the units have been held on to for less than 3 years from the unit allotment date prior to when they were switched to a different scheme or redeemed. These short-term capital gains are taxed under the income tax slab of the investor. These kinds of profit are included in the investor’s annual income in the ITR form, under the income from other sources head.
On the other hand, long-term capital gains of debt funds are generated in case the units of the mutual fund has been held for more than a period of 3years from the date of allocation prior to being redeemed or switched, These capital gains for debt funds are taxable at a rate of 20% with indexation.