Income Fund - Meaning, Features & Types

As tools of investment, adding diversification to any portfolio, mutual funds have emerged as winners. Over time, Indian investors have witnessed the rise of mutual funds with different plans that provide a range of lucrative returns depending on the type of investor and financial goals. In fact, there are so many kinds of funds available, investors are spoiled for choice. If you are an investor who is interested in a consistent income flow, you may consider an income fund. Known for its many pros, you can delve into an income fund’s advantages, know the types available, and more, in the following blog, helping you to decide to invest.  

What are income funds? 

Diving into the importance of income funds headfirst, it is important to understand that these are kinds of debt funds. Given this, an income fund will likely invest in instruments like government securities, corporate bonds, or debentures, or a combination of these. Moreover, such instruments are invested for lengthy timeframes, so they tend to yield a constant steady income for a long period. The Securities & Exchange Board of India (SEBI) categorises income funds as debt funds with a Macaulay Duration of 4 years and above.  

Types of Income Funds  

Income funds are broadly classified into types, based on the duration of the investment term. Hence, with respect to debt funds that come under the umbrella of income funds, there are two distinct kinds:  

• Medium to Long-Term Income Fund with a Macaulay Duration of 4 - 7 years 

• Long-term Income Fund with a Macaulay Duration of above 7 years 

As debt funds go, investors and financial professionals may also classify income funds into the types of instruments they invest in, such as in the following way:  

• Bond Income Funds: These funds invest their capital in municipal, corporate, and government securities. Investors can earn interest at regular intervals via investment in such funds.  

• Stocks that Pay Dividends: Concerning fixed income funds, some may invest a portion of their portfolio in equity that generates regular dividend payouts. These could be stocks of large-cap firms with a history of paying dividends consistently.  

• Other Securities: Other securities that generate more or less regular income include REITs (Real-estate Investment Trusts), preferred stocks, and money market instruments.  

How do income funds work? 

In relation to mutual funds, an income fund is one which is managed by a fund manager. Through an income fund, the fund manager aims to provide returns to investors, regardless of the state of current interest rates in the financial system. Simply put, income funds will likely deliver returns irrespective of whether general interest rates are dipping or surging. Thus, the active and timely management of the income fund’s portfolio is of prime importance. In view of this, fund managers practice any of the following principles:  

• Delivering Returns: Fund managers may sell debt instruments in an income fund if their prices have risen and profits can be realised.  

• Providing Income via Interest: An income fund, when held till its maturity, generates interest at regular intervals. This acts as a consistent source of income for investors.  

Fixed income funds, under the heading of “mutual funds”, tend to invest in instruments of debt possessing a high standard of security. That is, such funds invest their capital in high-quality instruments that hold premium ratings. This indicates that such funds come with a decreased risk arising from any interest-rate discrepancies. Moreover, income funds show a historical performance that outperforms the gains that conventional bank deposits (like fixed deposits) yield. Apart from this key feature, income funds offer investors the double advantage of liquidity and flexibility.   

Key Features of Income Mutual Funds 

Knowing the salient features of an income mutual fund stands you in good stead to make an investment decision. Here are the key features of Indian income funds:  

• Expenses 

Every mutual fund has an expense ratio. Essentially, the expense ratio represents the percentage of any fund’s total assets. The expense ratio of any given fund is levied as a charge or fee to investors of the fund. The said fee is charged for a fund’s administrative costs. The Securities & Exchange Board of India (SEBI) has mandated an expense ratio upper limit at 2.25% for income funds. Certain fixed income funds comprise debt instruments and may not yield high gains. Therefore, any income fund such as this may have a high expense ratio that potentially eats into an investor’s possible returns. As a result, investors may consider an income fund with a low expense ratio.  

• Investment Plan 

An income fund may be considered if investors wish to park their capital for long durations. Any investor that plans to invest for the long term, with a regular income stream, may think of an income fund.  

• Returns/Risks 

 As an income fund is a kind of debt mutual fund, you should be aware of the following, regarding returns and risks related to the fund:  

• Risks Involved: Interest funds have specific inherent risk factors that exist in the manner of credit risk and interest rate risk. Credit risk occurs in case the issuer fails to pay the interest and the principal. Interest rate risks may be felt as an effect of shifts in rates of interest on the value of the securities in the fund. Furthermore, a fund manager may see fit to invest in securities having a low rating in order to deliver high returns. The overall portfolio risk may well rise due to this.  

• Returns: Fixed income funds’ returns may be in the 7% to 9% range in a state of the economy where interest rates are plummeting. Leveraging interest-rate volatility, these funds tend to meet their investment goals.  

• Taxation: Now that you know the answer to the question, “What is an income fund?”, you may want to learn about the taxation these funds may be subjected to. Tax on any mutual fund is levied as capital gains tax. For an income fund, this is charged based on the holding period of the fund’s units. The holding period reflects the time between the buying of fund units and their redemption.  

In case the holding period lasts up to 3 years, short-term capital gains tax applies. Short-term capital gains (your returns for the period stated) are added to an investor’s taxable income. The total sum earned is then taxed according to the income bracket of the investor. Long-term capital gains tax is applied in the same way for any returns accrued after a 3-year holding period. This is taxed at 20% with the benefits of indexation.  

Advantages of Investing in Income Funds 

An income fund brings investors a host of benefits, highlighted below:  

• Investment Alternative: For investors with a low-risk profile and those who prefer fixed-income instruments, an income fund presents a viable option. Returns are potentially regular and steady. However, it may not be completely free from risk, as credit risk and interest rate risk may be considered. 

• Liquidity in Investment: Income funds are considered more liquid relative to conventional fixed deposits. Fixed deposits charge investors a penalty for withdrawals made prematurely, whereas income funds may be exited easily. However, it is crucial to check if an income fund has a heavy exit load levied.  

• Tax Advantages: In case investors lie within the highest income tax bracket of 30%, income funds may offer certain benefits in terms of taxation. Long-term capital gains are taxed at 20% along with indexation, but fixed deposit interest is charged according to an investor’s tax slab.  

Who should invest in income mutual funds? 

An income fund, on account of its very definition, may be considered a match for investors with low to medium tolerance for risk. For those investors seeking regular and stable returns, income funds may be a boon. If you take a conservative stance while investing, trying to learn about mutual funds for the first time, this low-risk option may be attractive for you.  

Conclusion 

If you want to allocate your capital for investment to income funds, you will discover that they yield a steady income stream. Besides capital appreciation, investors can earn an income regularly and this is an important aspect of their appeal. Typically, income funds invest their capital in instruments such as government securities, bonds, stocks that pay dividends regularly, debentures, and other instruments offering stable income. Known for their ability to gain returns, income funds provide higher returns than other fixed-income instruments like fixed deposits. Furthermore, income funds are attractive as they give you liquidity along with tax perks. All in all, they appear to be lucrative instruments, but it is essential for any investor to do adequate research before investing.