What is an Income Fund – A Low-Risk Option for Steady Returns

Key Takeaways
 

• An Income Fund is a type of debt mutual fund.
   
• It primarily invests in fixed-income securities to provide regular returns.
   
• Income Funds often yield higher returns than fixed deposits.
   
• They carry credit and interest rate risks, especially if not managed carefully.
   
• Income Funds help in diversifying a portfolio and balancing exposure to high-risk assets.

As mutual funds continue to evolve, investors are increasingly looking for stability to counterbalance the volatility of equity investments. A strategic way to do this is through debt funds, and among them, Income Funds stand out for their low-risk, income-generating approach. Let’s explore this in more detail.

What is an Income Fund?

An Income Fund is a form of Debt Mutual Fund that primarily invests in instruments like corporate bonds, government securities, treasury bills, commercial papers, and certificates of deposit. These funds are designed to provide a steady flow of income, rather than building wealth through capital appreciation.

They are best suited for investors who prefer long-term, low-risk instruments and are seeking regular income over high but uncertain returns.

How Does an Income Fund Work?

Income Funds are actively managed by professional fund managers. Their goal is to optimise returns regardless of market interest rate trends. They do this in two ways:
 

1. Hold securities till maturity to earn interest income.
    
2. Sell debt instruments when prices rise due to falling interest rates, booking capital gains.
    

For instance, if a fund manager buys a bond worth ₹1,00,000 offering a 7% interest rate, they could either:
 

• Hold it and earn ₹7,000 annually.
   
• Sell it in a falling rate market when bond prices increase, say at ₹1,05,000, earning a capital gain of ₹5,000.
   

Depending on market conditions, a skilled manager may blend both strategies to maximise your overall returns.

Benefits of Income Funds

1. Portfolio Diversification: By investing across various money markets and debt instruments, Income Funds bring a safety net to your overall investment mix. They help offset risks from volatile equity holdings.

2. Income: They’re ideal for individuals seeking an additional income stream. The interest received from debt instruments provides periodic earnings, which can be reinvested or withdrawn.

3. Returns: Historically, Income Funds have offered better returns than fixed deposits. For example, while a 5-year FD may yield 6% annually, an Income Fund might generate 7–8.5%, depending on market conditions and the fund’s risk exposure.

4. Liquidity: Unlike FDs, which penalise premature withdrawals, most Income Funds have no lock-in period. This provides you with greater access to your funds, although some may charge a small exit load if redeemed too soon.

Things to Consider

1. Risks

Income Funds are not completely risk-free. They carry:
 

• Interest rate risk – if interest rates rise, bond prices may fall, reducing the fund's value.
   
• Credit risk – the risk that the issuer of a debt instrument defaults on payment.
   

Some managers may take on lower-rated securities to chase higher returns, increasing the fund's exposure to risk.

2. Cost

Although flexible, these funds come with costs:
 

• Expense ratio: This is the annual fee charged by the fund house. A higher ratio can reduce your overall returns.
   
• Exit load: Some funds may charge up to 1% if you withdraw within a short time.
   

For example, if your fund returns 8% annually, but has an expense ratio of 2%, your actual return drops to 6%.

3. Taxation

Taxation on Income Funds depends on how long you hold your units:
 

• If held less than 3 years, any gains are taxed as Short-Term Capital Gains (STCG) and added to your income, taxed as per your slab (say, 30%).
   
• If held for over 3 years, gains qualify for Long-Term Capital Gains (LTCG), taxed at 20% with indexation.
  
  This can be particularly beneficial for high-income investors. For instance, if indexation reduces a ₹30,000 gain to ₹18,000, your tax liability is only ₹3,600 instead of ₹9,000.
   

A Comparative Look: Income Funds vs Fixed Deposits

To better understand the value proposition of Income Funds, here’s a side-by-side comparison with traditional Fixed Deposits (FDs):
 

This table highlights how Income Funds can outperform FDs in terms of post-tax returns, liquidity, and flexibility, especially for investors in higher tax brackets. For instance, a ₹2,00,000 investment in an Income Fund yielding 8% return and held for over three years with indexation could result in a lower tax outgo compared to an FD taxed at 30% slab.

In addition, the ability to redeem at any time without major penalties makes Income Funds an attractive option for investors needing liquidity without sacrificing returns.

Who Should Consider Investing in an Income Mutual Fund?

If you're someone with a moderate appetite for risk and your main goal is to earn regular, stable returns, then an Income Mutual Fund could be a smart addition to your portfolio. These funds are especially suitable for conservative investors who want to explore mutual funds but prefer to stay on the safer side of the investment spectrum.

Tax Implications

Tax treatment of Income Mutual Funds depends on how long you stay invested:
 

• Short-Term Capital Gains (STCG): If you hold the fund for up to 3 years, the gains are added to your income and taxed as per your income tax slab.
   
• Long-Term Capital Gains (LTCG): If you stay invested for more than 3 years, the gains are taxed at 20% with indexation benefits. This can help reduce your overall tax liability, especially if you're in a higher tax bracket.
   

Why Invest in Income Funds?

Here are a few reasons why income funds might be a good fit:
 

• They often outperform fixed deposits in terms of returns, though they come with slightly higher risk.
   
• Unlike fixed deposits, most income funds don’t have a lock-in period, giving you more flexibility. Just be sure to check if there's an exit load for early withdrawals.
   
• For high-income earners, these funds can be more tax-efficient compared to fixed deposits, especially when held for over three years. 

Conclusion

Income Funds are a realistic option for investors looking for a blend of safety, returns, and liquidity. While they do include some risk, their potential for higher post-tax returns and flexibility make them particularly intriguing for medium to long-term goals. With the correct time and fund selection, Income Funds can be a reliable component of any well-diversified portfolio.

Frequently Asked Questions (FAQ): 

Can I lose money in an Income Fund?
Yes, Income Funds, while generally low-risk, are not risk-free. Losses may occur as a result of interest rate changes or defaults by issuers of debt instruments held by the fund.

How frequently do Income Funds pay out returns?
Income funds may provide growth or dividend alternatives. Dividend payouts might occur monthly, quarterly, or annually, depending on the scheme. Returns on the growth option are realised when the investment is redeemed.

Will I require a demat account to invest in an Income Fund?
No, a demat account isn't required. You can invest through mutual fund platforms, banks, or directly with the fund firm, both online and offline.

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‘Simplify Finance for Everyone.’ This is the common goal of our team, as we try to explain any topic with relatable examples. From personal to business finance, managing EMIs to becoming debt-free, we do extensive research on each and every parameter, so you don’t have to. Scroll up and have a look at what 15+ years of experience in the BFSI sector looks like.