What are Income Funds in Mutual Funds & How to Invest: Meaning & Examples

Income funds refer to a mutual fund or unit-linked investment plan (ULIP) that aims to provide investors with a consistent income stream. Usually, income funds generate revenue through interest payments or dividends. They are usually organized through financial institutions and comprise bonds, dividend-paying stocks, corporate or government debt obligations, etc. Income funds are generally considered a low-risk alternative for investors as they feature stocks with a fair track record of paying dividends.

How Do Income Funds Work?

Income funds typically produce returns leveraging two basic strategies - either they hold stocks until maturity and sell them when the price amplifies, or the fund manager provides the best returns by investing in money market instruments and debt with low risk and better stability.

How Many Types of Income Funds Are There?

Income funds have four categories. They include the following -

Bond Funds

This income fund comprises government and corporate bond investments. Government bonds are virtually zero risk and ideal for investors looking for a safe alternative. However, due to their low-risk approach, government bonds usually offer lower dividend yields. Corporate bonds, on the other hand, offer better yields. However, they involve some additional risks.

Real Estate Investment Trusts (REITs)

A Real Estate Investment Trust (REIT) refers to an organization that owns finances or operates income-driving real estate. REITs are modeled after mutual funds, and they pool numerous investors’ capital. Due to this reason, it allows individual investors to earn dividends from real estate investments without forcing them to buy, manage, or finance any property. Typically, most REITs are traded publicly. Thus, they are highly liquid. REITs invest in various real estate property types like data centers, buildings, cell towers, retail centers, hotels, warehouses, etc.

Equity Income Funds

Featuring a distinct blend of income-producing securities, equity income funds primarily generate income from dividends and stocks. These stocks or dividends are usually cash payments from organizations to their stakeholders that work as a reward for investing in their stock. In other words, equity income refers to the money earned from stock dividends that investors can access by acquiring dividend-paying funds or stocks.

Equity income funds are designed for conservative investors who prefer long-term income solutions. However, investing in these funds requires a little homework. For instance, investors should always find quality stocks with high dividend yields. Besides, they should check for dividend reinvestment programs and tax implications.

Money Market Funds

Money market funds refer to short-term debt funds. As the name suggests, they invest in different money market instruments and offer satisfactory returns over a span of around 12 months. These funds typically maintain high levels of liquidity. There are several types of money market instruments, including the following.

Certificate of Deposit: CD or Certificate of Deposit usually comes from specific commercial banks that don’t allow premature redemption. Unlike FDs or fixed deposits, CDs are negotiable.

Commercial paper: Financial institutions that hold higher credit ratings often issue an unsecured and short-term promissory note. These notes allow those entities to diversify their short-term borrowing sources. While CPs are redeemed at face value, they are issued at a discounted rate. Investors can earn the difference.

T-bills or Treasury Bills: T-bills or treasury bills are issued by the Government of India. These fundraising instruments are pretty safe. However, they offer lower returns.

Repose: A repose or repurchase agreement refers to the contract between the RBI and a bank to facilitate short-term loans. Often, repose is signed between two banks or financial institutes.

Benefits of Income Funds

Income funds ensure potential risk aversion. Besides, they offer a slew of additional benefits. They include the following.

Straight Forward Investment

Investors can manage income funds conveniently. They allow individuals to determine their monthly budget and earn regular returns accordingly. Even beginners with limited financial knowledge can manage these funds efficiently.

Highly Diverse

Leveraging income funds, investors may earn exposure to an assortment of different asset classes. Consequently, they receive the opportunity to diversify their portfolio.

Low Expense Ratio

Generally, income funds feature low expense ratios. Therefore, investors can easily amplify their earnings against their investments.

Tax Benefits

Investors liable to pay the highest income tax bracket can enjoy significant tax benefits when investing in income funds.

Zero Lock-in Periods

Income funds don’t feature any lock-in periods. Hence, there is no risk of paying penalties in case of premature withdrawals.

Investing in Income Funds - Factors to Check

Before investing in income funds, individuals need to check a few factors, including the following.

Cost

There’s a certain fee associated with income funds levied on investors for fund management. Known as the expense ratio, this increases the cost of income funds a little, and investors should check this factor carefully before investing.

Investment Objectives

Income funds allow individuals to invest in securities that produce high income. Given this, such funds can turn out to be extremely helpful in fulfilling the investor’s short-term financial goals and income objectives.

Investment Span

With income funds, individuals will always have an investment horizon of a maximum of three years. Therefore, they should think carefully if the said investment horizon aligns with their investment objectives.

Risk

Income funds can be excellent investment instruments. However, they carry credit risk and interest rate risks. As such, the impact of changes in interest rates will always be there on the value of the fund security. On the other hand, if the issuer doesn’t repay the interest and principal, the investor can experience a significant loss.

Fund Manager’s Background

Besides choosing a fund that ensures the best returns and fantastic expense ratio, it’s imperative to check the background of the fund manager. This will help investors choose genuine and authoritative funds.

Frequently Asked Questions

Does an income fund pose any risk?

Like any other financial instrument, income funds also pose certain risks. However, they are relatively safer alternatives within equity.

How to choose an income fund?

Investors can consider several factors to determine the quality of an income fund. They include independent fund ratings, risks, performance figures, investment horizon, etc.

Is an income fund a wise investment?

Yes, it is. An income fund may offer you broad exposure to different asset classes. Besides, it may help you diversify your investment portfolio. However, like any other form of investment, income funds also have some risks. Therefore, invest carefully.

Takeaway

Income funds aim to help investors generate an income stream by investing in fixed-income securities. Anyone looking for a stable and regular income can consider these low-risk investment instruments. Leveraging income funds, an investor can earn fantastic returns by leveraging interest rate volatility and exposure to a broader asset class.