Income funds advised when interest rates rise

The RBI increased the policy rates by 50 basis points recently. That will push up interest rates. When rates are peaking, experts advise investors to invest in income funds.

An income fund is an open-ended mutual fund scheme that invests in fixed-income instruments of varying maturities to generate regular income from the coupon payouts from the instruments. The fund invests in certificates of deposit, commercial paper, government bonds, debentures and securitised debt to build a diversified portfolio offering good risk-adjusted returns.

The fund manager may choose to invest in call money market, treasury bills and collateralised borrowing and lending obligation ( CBLO), to maintain liquidity requirements. Fund managers consider credit rating of fixed income instruments before investing in them.

The returns payable by funds are influenced due to changes in interest rates. The returns generated by an income fund include both the coupon payments and capital gains. Higher the coupon – the rate at which interest is paid by the borrower — higher the income for the investor. Also, the higher the coupon, the lower the credit rating of the bond, other things remaining the same.

The fund manager of an income fund does his best to strike a balance between the credit rating and yield of the portfolio. Capital gains are a function of interest rate changes. If the interest rates were to move up, the fixed income instruments, especially those with longer maturities, see a fall in price. This, in turn, results in a capital loss and a lower net asset value (NAV) of the fund.

On the other hand, if the interest rates move down, the fixed income instruments see prices appreciate. This brings capital gains to the fund and the NAV appreciates. Income funds make a better choice for fixed-income instruments when the interest rates are peaking.

One can invest in an income fund with as low as Rs 5,000 to start with. One can also opt for a systematic investment plan. The ideal time frame for investments in an income fund is one to two-three years. Though income funds do not charge an entry load, there is an exit load in place. Investors looking for regular income should look at the dividend option. The growth option works for investors looking to save for the future.