Investing in debt via Income funds

Income funds are a common form of debt investment. They are suitable for investors with a medium to long term investment horizon and a moderate appetite for risk. There are a few key differences between income fund and other debt investments such as liquid funds and fixed maturity plans.

The structure of an income fund

Income funds are open ended debt schemes that invest in a variety of debt securities including corporate bonds and debentures certificates of deposit (conceptuality similar to bank fixed deposits), government securities.

The fund manager varies the proportion of these instruments in the portfolio and their maturities. Typically substantial parts of the portfolio are in medium to long term debt, so income funds are suitable for investors with a short term investment horizon (say 9 months or less). Such investors would probably be better served by short term liquid funds.

Income funds are tax efficient; dividends are subject to a dividend distribution tax rather than to income tax.

Unlike a bank fixed deposit an income fund does not offer a guaranteed arte of return. There are two ways in which income funds earn their returns

1) interest income
2) income from buying and selling securities

Interest Income

All debt securities are interest bearing, so the portfolio generates steady stream of interest income. The actual rate of interest paid by a given security depends largely on two factors:

Benchmark interest rates prevailing in the economy

The yields available on the safest securities such as government bonds, serve as a benchmark for yields on all other debt securities.

The yields on these benchmark government securities are mostly determined by market expectations of RBI policies and government borrowing programs.

The credit risk of the borrower

All corporate or private borrowers must borrow at higher rates of interest than those offered by benchmark government securities . This is because lenders demand compensation for the credit risk of default. (Government securities are considered free of this risk). The difference in yield between the borrower’s bond and that of a similar risk free government bond is called the spread.

Income from buying and selling securities

In addition to the interest income earned from the fund portfolio income fund also generate returns by judiciously buying ad selling bonds to alter the composition of the portfolio.

For instance, if the manager of the income fund believes that the economy is set for a sharp upturn, he might increase his allocation of relatively risky but high yielding bonds. As the economy recovers, the credit spread of riskier borrower will fall. The prices of their bonds will then increase, so the fund manager can then sell them at a profit. This profit is over an above the interest income from those bonds.

Note that while income funds do take on some credit risk, they carefully scrutinize the credit ratings of their borrowers and stick to highly rated securities the level of risk is usually lower than say, in equity investing.

The fund manager can also after the portion to reflect changing interest a rate expectations. For instance, if the economy is set to slow down, the RBI might be expected to cut interest rates to stimulate growth. The fund might then switch to safe long term government bonds. If the RBI does lower interest rtes, existing bonds will increase in price. The fund manager can then sell these bonds for a profit.

Income funds Vs Liquid funds

Both income funds and liquid funds are open ended debt schemes which allow investors to exit at any point. Income funds are however, more likely to levy exit loads.

Income funds differ from liquid funds both in investment horizon and risk profile. Liquid funds invest in very short term securities with negligible credit risk. Income funds invest in a range of maturities and risk levels, offering higher returns albeit accompanied by a higher level of risk.

Summing Up

Income fund portfolios are actively managed with a view on interest rate movements by keeping a close watch on various parameters. They generate returns both from the interest that accrues for debt instruments, as well as from buying and selling those instruments. They are suitable for investors with moderate risk appetite and a medium to long term investment horizon.

Income funds are a common form of debt investment. They are suitable for investors with a medium to long term investment horizon and a moderate appetite for risk. There are a few key differences between income fund and other debt investments such as liquid funds and fixed maturity plans.

The structure of an income fund

Income funds are open ended debt schemes that invest in a variety of debt securities including corporate bonds and debentures certificates of deposit (conceptuality similar to bank fixed deposits), government securities.

The fund manager varies the proportion of these instruments in the portfolio and their maturities. Typically substantial parts of the portfolio are in medium to long term debt, so income funds are suitable for investors with a short term investment horizon (say 9 months or less). Such investors would probably be better served by short term liquid funds.

Income funds are tax efficient; dividends are subject to a dividend distribution tax rather than to income tax.

Unlike a bank fixed deposit an income fund does not offer a guaranteed arte of return. There are two ways in which income funds earn their returns

1) interest income
2) income from buying and selling securities

Interest Income

All debt securities are interest bearing, so the portfolio generates steady stream of interest income. The actual rate of interest paid by a given security depends largely on two factors:

Benchmark interest rates prevailing in the economy

The yields available on the safest securities such as government bonds, serve as a benchmark for yields on all other debt securities.

The yields on these benchmark government securities are mostly determined by market expectations of RBI policies and government borrowing programs.

The credit risk of the borrower

All corporate or private borrowers must borrow at higher rates of interest than those offered by benchmark government securities . This is because lenders demand compensation for the credit risk of default. (Government securities are considered free of this risk). The difference in yield between the borrower’s bond and that of a similar risk free government bond is called the spread.

Income from buying and selling securities

In addition to the interest income earned from the fund portfolio income fund also generate returns by judiciously buying ad selling bonds to alter the composition of the portfolio.

For instance, if the manager of the income fund believes that the economy is set for a sharp upturn, he might increase his allocation of relatively risky but high yielding bonds. As the economy recovers, the credit spread of riskier borrower will fall. The prices of their bonds will then increase, so the fund manager can then sell them at a profit. This profit is over an above the interest income from those bonds.

Note that while income funds do take on some credit risk, they carefully scrutinize the credit ratings of their borrowers and stick to highly rated securities the level of risk is usually lower than say, in equity investing.

The fund manager can also after the portion to reflect changing interest a rate expectations. For instance, if the economy is set to slow down, the RBI might be expected to cut interest rates to stimulate growth. The fund might then switch to safe long term government bonds. If the RBI does lower interest rtes, existing bonds will increase in price. The fund manager can then sell these bonds for a profit.

Income funds Vs Liquid funds

Both income funds and liquid funds are open ended debt schemes which allow investors to exit at any point. Income funds are however, more likely to levy exit loads.

Income funds differ from liquid funds both in investment horizon and risk profile. Liquid funds invest in very short term securities with negligible credit risk. Income funds invest in a range of maturities and risk levels, offering higher returns albeit accompanied by a higher level of risk.

Summing Up

Income fund portfolios are actively managed with a view on interest rate movements by keeping a close watch on various parameters. They generate returns both from the interest that accrues for debt instruments, as well as from buying and selling those instruments. They are suitable for investors with moderate risk appetite and a medium to long term investment horizon.

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