Income Funds which are also known as long term debt funds, are good investment options for investors, who look for certain degree of assurance with regards to risk and return and at the same time, want to get better income than fixed deposits over a medium to long term investment horizon
Investors should understand the meaning of risk as they often confuse it with volatility. As mutual funds invest in capital market securities, the prices fluctuate on a day to day basis and sometimes may be up or down for weeks or months. This is known as volatility. For example – on a particular day, your mutual fund investment value may be up or down depending on the market conditions. However, risk is the probability of making a loss when you redeem your investments. Therefore, the tenure of your investment has a big role in the risk profile of your investments.
Even though income funds are debts funds, they can be fairly volatile in the short term since they invest in long dated bonds, i.e. bonds with longer maturities. The longer maturity profiles of income funds expose them to higher interest rate risk, because interest rate sensitivity of bond prices are directly related to their maturity profiles. However, investors should know that, long dated bonds pay more interest (coupons) than short dated bonds.
Over sufficiently long investment tenures, higher yields (income) from long term bonds offset negative price movements during the term of investment. Further, investors should also remember that, interest rate movement is not unidirectional indefinitely; therefore, a period of rising interest rates is followed by a period of falling interest rates. A long investment tenure (3 years or longer) of a debt fund, is likely to have periods of both rising and falling interest rates, therefore, when the interest rate falls, bond prices rise and income fund investors see capital appreciation. Some investors however, have a perception that, income funds are as risky as equity funds which is completely untrue.
Income funds gave excellent returns during the last 5 years period; some top performing income funds gave even double digit returns. In fact, over the last 5 years, top income funds gave between 9 – 11% annualized returns. So one should not judge the performance of income funds based on short term trailing returns because it is influenced by the current interest rate environment. Over a longer period of time, which includes both periods of rising and falling interest rates, income funds benefit both from higher coupon rates, as well as from the price appreciation which offsets return declines.
While selecting debt mutual funds for your investments, it is very important to align your investment needs with your tenure, risk appetite and liquidity needs. Long term debt funds or income funds can be fairly volatile in the short term and so a long investment tenure (3 years plus) is recommended.
You should also know what are different types of debt mutual funds in India
Despite the recent underperformance, income funds remain good investment choices for conservative investors with long investment tenures looking for better than fixed income investment returns. Over 3 years plus investment tenures, income funds enjoy considerable tax advantage over fixed deposits. Fixed deposit interest is taxed as per the income tax rate of the investor, whereas in income fund long term capital gains are taxed at 20% after allowing for indexation benefits. Indexation benefits reduce the tax burden considerably for investors in the higher tax brackets.
If you want to invest in income funds, do check the top income funds here.