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Wednesday, June 12, 2013

What are Income Funds

If you are a novice to mutual fund investments, it can be difficult to pick the right ones given the number of schemes on offer. I am starting a series of fund types available in the market. This first post in the series deals with Income Funds.

What are Income Funds?
An income fund is a mutual fund whose goal is to provide an income from investments.
Income funds are often assumed to be bond funds, but they may be stock funds instead, more accurately called equity income funds. Typically these hold stocks with a good history of paying dividends. In fact, a typical income fund holds both stocks and bonds, to gain some of the strengths of both.

The point in any case is that the investor is more interested in income than capital gains, perhaps with the intention the fund will never be sold.

Who manages Income Funds?
They are managed by expert fund managers who actively try to manage the portfolio based on interest rate movements, while at the same time keeping the portfolio credit worthy.In other words, they seek to generate returns both in declining and rising interest rate scenarios by managing their portfolio actively. They either generate interest income by holding the instruments till maturity or manage gains by selling them in the debt market if the price of the instrument rallies well.

If you are investing for not less than two years, then ‘income funds’ a class of debt mutual funds can deliver superior returns compared with bank deposits. That means you can earn a bit more than traditional debt avenues, by still staying invested in debt.

Income fund advantages
• Highly liquid. Can with draw money anytime unlike fixed deposits that come with a fixed lock-in period
• Actively managed. Seek to generate returns from varying interest rate cycles
• Have historically generated superior post tax returns than fixed deposits.
• Very tax efficient, especially for those in the 20% and 30% tax brackets. Long-term capital gains (for holding over one year) are taxed at 10% without indexation or 20% with indexation. Interest on fixed deposits, though, is taxed at your income slab.
• Offers high flexibility. Besides investing systematically you can even withdraw money systematically thus generating regular cash flow for yourself.


How to use income funds?
• Invest your money in a combination of traditional fixed income options such as deposits and income funds to pep overall returns. You need not put your money in one basket.
• When you build a mutual fund portfolio, consider investing over one half of your capital in income funds when you have a time frame of say 2-3 years
• Use income funds, along with equity funds, as part of a long-term asset allocation strategy to build wealth.
• You can use income funds to also provide for some monthly cash flows by opting for a systematic withdrawal plan after first holding it for at least two years.

Words of Caution
 The returns depend on the fund manager's ability to make the right calls on interest movements.
 If you have a time frame of less than 18 months, there are other short-term debt schemes that mutual funds offer. Income funds will not fit a short time frame. 
 Income funds do not guarantee fixed returns nor are they covered by insurance as is the case with bank fixed deposits (up to Rs 1 lakh). To this extent, they do not top the safety chart.

Cheers

Manoj Arora

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