Income funds are those mutual funds which invest in bonds and government securities.
Income funds have exposure to corporate bonds and government securities of varying maturities, and are classified as short, mid and long term.
Coupon Bearing Bonds: These bonds are issued at face value and have a coupon which is paid annually/semi-annually or quarterly varying from company to company. At maturity, investors would get the face value plus the interest accrued between the last coupon paid and the maturity.
Zero Coupon Bonds / Deep Discount Bonds: These bonds do not have a coupon and are issued at a discount to the face value. At maturity, an investor would get the face value.
These are traded in the secondary market and the yield-to-maturity is calculated based on the remaining maturity period, price of bond, and also the coupon in case of coupon bearing bonds.
A fund manager with the help of a research team reviews the situation and takes exposure in the bonds of different maturities.
Apart from holding the bonds with higher yields, they can also sell the bonds in the secondary market for capital appreciation.
Dated Government Securities: More popularly known as GILTs, they are issued by the central government and are long term borrowing instruments that vary in maturities up to 30 years. The interest is paid mostly half-yearly unless specified and coupon is either fixed or floating. They are sold through a process of auction by the RBI. Being government securities, they carry a lowerinterest rate compared to corporate bonds but still enjoy a lot of demand in the secondary market.
State Development Loans: Similar to GILTs issued by central government, these are dated securities issued by State Government. These also are issued through an auction process similar to GILTs and interest is paid on a half-yearly basis
How does an Income Fund work?
When interest rates come down, higher coupon bearing bonds will have higher demand and have double the benefit of earning higher coupons or when sold in the market also attract higher bargain price thus, there will also be a capital gain apart from the high coupon which is received on an annual/semi-annual basis. Let us assume there is a 12 year bond with 10.5% coupon which is bought at Rs 100.
In case in two years time, interest rates come down and new bonds are available with 10 years maturity offer you 8.5% and one is looking at an internal rate of return (IRR) of 9.5%. The 10.5% bond can be bought at Rs 106.28. So, in case the initial buyer of the bond sells it in the market at 106.28, he would have earned a return of 12.84%, or hold the bond till maturity and get 10.5% p.a. Let us assume there is a 4 year bond with 10.5% coupon which is bought at Rs 100.
2 years maturity offers you 8.5% and one is looking at an IRR of 9.5%. The 10.5% bond can be bought at Rs 103.2. In case the initial buyer of the bond sells it in the market at Rs 103.2, he would have earned a return of 11.46% or hold the bond till maturity and get 10.5% p.a.
Thus, a longer maturity bond not only gives you higher rate for longer tenure till maturity, but also provides an opportunity to generate capital gains. Income funds are a good, stable hedge against economic uncertainty.
The Current Scenario
Based on the interest rate scenario one can capitalize by investing in income funds of various maturities. Let us take the case of the current scenario where if RBI goes for rate cuts in the further monetary policy review meetings. The intensity in the rate cut by RBI again depends on various factors. For the time being, we would assume RBI goes in for a 25 bps rate cut in the upcoming review. What happens then is that, the fresh papers which would come into the market will have lower interest rates. Thus, for an investor to have higher interest rates they have to go into the sec- ondary market and buy. In this situation, when the expectation is that RBI may resort to rate cuts to the extent of 20-50 bps in the next year and a half period, the demand for higher interest yielding in- struments traded in the secondary market will have huge demand. This gives an op- portunity to the investor who is currently holding the higher interest bearing bonds to either hold it till maturity or sell them in the secondary market at a premium thereby getting capital appreciation. For a buy side investor, the idea would be to calculate the price at which a bond can be bought so that, even on paying a premium, he still can get effective yield higher than the available papers on offer.
Repo Rate
Repo rate is the rate at which RBI lends money to banks. Thus when banks bor- row money, they have to pay them interest of 6.25% (as per the current rate), thus this is important for normal public as well as the companies as this would form the basis of the lending rates by Banks. The repo rate is currently at 6.25% after RBI has decided to maintain the status quo in the last monetary policy review. Many including the corporate sector would expect rate cuts going forward. Now that Inflation seems to have been coming down drastically, rate cut seems to be on the cards in the next review.
Overall, income funds form a good base for an investor to consider investments in them as they have the capability of delivering competitive returns in the current scenario. Investors who are looking for stable returns mainly for the purpose of retirement may consider having certain allocation to these funds.
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