A fixed income mutual fund, also called an income or debt fund, invests in fixed-income securities like government bonds, corporate bonds, debentures, and money market instruments to generate returns for investors. One of the many advantages of mutual funds is the abundance of options available. There are multiple types of funds, each with its own set of advantages and risks. Among the most popular types are fixed-income mutual funds. They are a popular choice among investors seeking stable returns and capital preservation. Here is everything you need to know about this investment option.
What are fixed-income funds?
Fixed Income Mutual Funds are investment vehicles that primarily invest in fixed-income securities, such as bonds, government securities, treasury bills, and corporate debt. These funds aim to provide investors with regular income and capital preservation while reducing the volatility typically associated with equity investments.
The primary objective of fixed income mutual funds is to generate consistent returns through interest payments and capital appreciation. They are particularly attractive to conservative investors seeking lower risk and predictable income streams. Fund managers actively manage these portfolios, selecting securities based on interest rate movements, credit quality, and overall economic conditions.
Fixed-income funds can be classified into various categories, including short-term, medium-term, and long-term funds, each with distinct risk and return profiles. Overall, these funds serve as a valuable component of a diversified investment portfolio, balancing risk and enhancing overall returns.
Most fixed-income mutual funds generate returns by investing in bonds and other fixed-income securities. Practically, these funds buy bonds and earn interest from them. It must be noted that how you earn income from fixed-income mutual funds is comparable to how you earn interest from a fixed deposit (FD). In both cases, the income you receive comes from the interest generated by the investment. For fixed-income mutual funds, this interest comes from the bonds they hold, while for an FD, it's the interest paid by the bank. So, if you invest in either, you're earning returns primarily from interest income.
Corporate bonds, government bonds, municipal bonds, Treasury Bills (T-Bills), Commercial Paper (CP), Certificates of Deposit (CDs) and repurchase agreements are some of the common debt instruments that fixed-income funds invest in.
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Features and advantages of fixed-income mutual funds
Fixed-income mutual funds offer a range of features and advantages that make them attractive investment options for many investors. Here is a closer look at a few of them.
Stable income stream
The regular interest payments from the underlying debt securities in the funds provide investors with a stable and predictable income stream. This makes them particularly beneficial for investors seeking a steady income to meet their financial needs or goals.
Diversification
Fixed-income mutual funds typically invest in multiple debt securities with different credit ratings and maturities. This diversifies the portfolio and spreads risk across different assets, reducing the negative impact of adverse events.
Professional management
Fixed-income funds are managed by professional fund managers with decades of experience navigating the financial markets. The fund managers select the appropriate securities for the fund’s portfolio, actively monitor the markets and adjust the holdings according to market conditions.
Capital preservation
Fixed-income funds prioritise capital preservation over wealth creation. Although they may not offer the same level of capital appreciation as equity funds, they generate a steady stream of income for investors.
Liquidity
Investors can freely buy and redeem units of fixed-income mutual funds. The high level of liquidity allows investors to access their investment capital as and when they need to cover emergency expenses.
Components of fixed-income funds
Fixed-income funds are a type of mutual fund that focuses on generating steady income through investments in various types of debt instruments. These funds are less risky compared to equity investments and provide stable returns. Below are some main components of fixed-income mutual funds:
Debt funds
Debt funds invest in relatively safe debt instruments such as government bonds, corporate bonds, debentures, and other securities. The goal of debt funds is to generate stable returns through interest income while maintaining a lower risk profile than stocks.
Money market funds
Money market funds invest in short-term and highly liquid instruments like treasury bills, commercial paper, and short-term bank certificates of deposit (CDs). These funds are suitable for short-term investments (usually up to 90 days), and their returns are directly influenced by changes in interest rates.
Exchange-traded funds (ETFs)
Exchange-traded funds (ETFs) are index funds that are traded on stock exchanges. They replicate the performance of a specific index, such as Nifty, BSE Sensex, or S&P. ETFs allow investors to buy and sell shares on the cash market daily, which provides flexibility. Moreover, ETFs can also track commodities with Gold ETFs (tracks the performance of gold) being a popular example.
Different types of fixed-income funds
Fixed-income mutual funds come in various types, each with its own unique characteristics and investment objectives. Some of the most common types of fixed-income mutual fund schemes that are available in India include the following.
Long-term debt funds
Long-term debt funds invest in corporate and government debt securities with maturities ranging from three to ten years. They are ideal for investors with a long-term investment horizon.
Short-term debt funds
Short-term debt funds invest in a range of different debt securities with maturities ranging from one to three years, making them ideal investment options for investors looking for safe, short-term investment opportunities.
Floating rate funds
Floating rate funds invest in debt securities that offer a floating rate of interest, often linked to the Mumbai Interbank Offer Rate (MIBOR). The primary aim of these funds is to minimise the volatility in the fund when interest rates change.
Credit opportunity funds
Credit opportunity funds invest in corporate bonds that have less-than-ideal credit ratings. These bonds usually offer higher interest rates to compensate for their low ratings. These funds are ideal for investors with high-risk tolerance since they carry a higher risk of default.
Gilt funds
Gilt funds invest exclusively in government securities with both short-term and long-term maturities. Since these funds invest in central and state government-issued securities, . However, they are very prone to interest rate risk, especially if their tenure is long.
Liquid funds
Liquid funds invest in debt instruments with maturities of up to 91 days. These funds have very high levels of liquidity and can be redeemed quickly within one day.
Dynamic bond funds
Dynamic bond funds invest in debt securities with different maturities. These funds are actively managed by fund managers who dynamically adjust the fund’s portfolio depending on the market conditions and their view on interest rate movements.
Measuring fixed income fund performance
Understanding fixed income fund performance
Measuring the performance of fixed income funds involves several metrics that assess their returns, risk levels, and overall efficiency. Investors typically look at both quantitative and qualitative factors to determine how well a fund meets its investment objectives.
Total return
Total return is a crucial measure, representing the sum of interest income, capital gains, and any changes in the fund's net asset value (NAV) over a specific period. This metric helps investors understand the overall profitability of their investment. A higher total return indicates better performance relative to the initial investment.
Yield to maturity
Yield to maturity (YTM) is another essential metric, indicating the total return anticipated on a bond if held until maturity. This figure helps investors compare fixed income funds against each other and assess whether the yield justifies the associated risks.
Sharpe ratio
The Sharpe ratio measures the risk-adjusted return of a fund. It compares the excess return of the fund to its standard deviation, providing insight into how well the fund compensates investors for the risk taken. A higher Sharpe ratio indicates a more efficient investment.
Benchmark comparison
Comparing a fixed income fund's performance against relevant benchmarks, such as bond indices, is vital. This comparison helps investors evaluate whether the fund manager is adding value through active management.
Conclusion
By considering these metrics, investors can make informed decisions about their fixed income investments and align them with their financial goals.
Are fixed-income funds better than bank FDs?
Both bank fixed deposits and fixed-income funds are attractive investment options, each with its own set of characteristics.
Cooperative & commercial bank FDs, for instance, are relatively safe and have deposit guarantees to the tune of Rs. 5 lakh by DIGCC as per RBI. However, these mutual funds’ returns usually tend to be low, especially during low-interest-rate environments. This makes them suitable for conservative investors seeking capital preservation
Fixed-income mutual funds, on the other hand, provide investors with the opportunity to earn higher returns compared to traditional bank FDs, especially in the long term. This makes them suitable for investors who are willing to take on some level of risk in exchange for the potential for higher returns.
However, the choice between bank FDs and fixed-income mutual funds ultimately depends on the investor's risk tolerance, investment objectives and time horizon.
Why invest in fixed income funds?
1. Steady income generation
Fixed-income funds offer a reliable source of income by investing in bonds and other debt instruments that pay regular interest. Investors receive consistent returns in the form of interest payments, making these funds suitable for those seeking stable, periodic income. This steady income stream is especially attractive to conservative investors, such as retirees, who prioritise capital preservation and predictable earnings over higher-risk investments like equities.
2. Lower risk compared to equities
Fixed-income funds are generally considered less volatile than equity investments. Since they focus on debt instruments, which promise a fixed return over time, the risk of capital loss is lower. While these funds do not guarantee returns like fixed deposits, they are still a safer option compared to the stock market, where price fluctuations can be more dramatic.
3. Portfolio diversification
Investing in fixed-income funds helps diversify a portfolio by balancing high-risk investments with more stable, predictable returns. Bonds typically perform well when equities decline, offering protection during market downturns. Including fixed-income securities reduces the overall risk and volatility of an investment portfolio, ensuring better risk management.
4. Liquidity
Unlike fixed deposits or other long-term savings products, fixed-income funds offer liquidity, meaning investors can access their funds when needed. These funds are often traded on stock exchanges, making it easy for investors to sell their holdings and obtain cash without lengthy waiting periods. This liquidity makes fixed-income funds an attractive option for those seeking flexibility in their investments.
5. Potential for Capital Appreciation
Though fixed-income funds primarily focus on earning interest, they can also provide capital appreciation. When interest rates decline, the value of existing bonds in the fund rises, allowing investors to benefit from higher bond prices. This offers the potential for capital gains in addition to the regular income from interest, enhancing overall returns in a low-interest-rate environment.
Who should invest in fixed-income bond funds?
Fixed-income bond funds are particularly suitable for investors who seek a steady and reliable source of income. It is not for investors who focus more on increasing the overall value of their investment portfolio. Hence, these funds are an attractive option for retirees and others who need consistent income to meet their financial needs.
It is worth mentioning that mostly the proportion of an investment portfolio allocated to fixed-income funds varies based on an individual's:
- Risk tolerance
and - Investment objectives
For those with a low-risk tolerance or a need for stable returns, a higher allocation to fixed-income funds is advisable. On the other hand, those willing to accept more risk (in expectation of earning higher returns) can invest more in stocks.
However, maintaining a balanced approach often involves a mix of fixed-income products and equities, such as a 50/50 split. Such an allocation/ split provides both stability and growth potential in the portfolio.
Taxability on fixed-income mutual funds
Most investors confuse the taxability of fixed-income mutual funds with that of bank fixed deposits (FDs). Be aware that both are different investment products and are taxed differently. For bank FDs, the interest earned, whether received or accrued, is added to your taxable income, which is then taxed as per your slab rates. Also, the bank deducts 10% TDS on the interest, unless you submit Form 15G to declare no taxable income.
On the other hand, debt mutual funds are taxed only when you redeem your units. If you sell your units within 24 months (reduced from the earlier limit of 36 months in the Union Budget 2024), you incur Short-Term Capital Gains (STCG) tax, which is taxed as per the applicable rates.
For investments held longer than 24 months, the Long-Term Capital Gains (LTCG) tax applies. LTCG on debt mutual funds is exempt up to Rs. 1,25,000 (up from the previous limit of Rs. 1,00,000). Any gain beyond this threshold is taxed at 12.50% (up from the previous limit of 10%). Also, it must be noted that after the recent changes proposed in the Union Budget 2024, the indexation benefits have been discontinued.
Recommended fixed income mutual funds for 2024
- Aditya Birla Sun Life Medium Term Fund
- ICICI Pru All Seasons Bond Fund
- ICICI Pru Credit Risk Fund
- Nippon India Nivesh Lakshya Fund
- Edelweiss Banking and PSU Debt Fund
- ICICI Pru Short Term Fund
- HSBC Corporate Bond Fund
Risks involved while investing in fixed-income mutual funds
Investing in fixed-income mutual funds comes with certain risks that investors need to be aware of. The two main risks are interest rate risk and credit risk. Let’s understand them in detail:
Interest rate risk
Interest rate risk affects the prices of fixed-income securities. As a thumb rule, these prices move inversely to changes in interest rates. In simple words, when interest rates rise, the prices of these securities fall, and when interest rates fall, the prices of fixed-income securities increase. This sensitivity of a fixed income instrument to interest rate changes is known as its duration. Generally, instruments with longer durations are more sensitive to interest rate fluctuations. This implies prices of such securities are more likely to change significantly in response to rate changes.
Credit risk
Credit risk refers to the possibility that the issuer of a fixed-income security might default on its interest or principal payments. For this reason, credit rating agencies assess the financial strength of issuers and assign credit ratings to their instruments. Now, if an instrument's credit rating is downgraded due to the issuer's deteriorating financial condition, its price usually falls. On the other hand, an upgrade in the credit rating generally leads to a price increase. Investors should always consider this risk while considering the credit quality of the securities within a fixed-income mutual fund.
Factors to consider before investing in fixed-income mutual funds
Fixed-income mutual funds appeal to those looking to earn a stable income and moderate growth. However, several factors need to be considered before buying fixed-income mutual funds, such as:
Financial goals
First, identify your financial goals. Determine if you are looking for additional income or higher returns compared to a regular savings account. Now, choose a fixed-income mutual fund that aligns with your specific objectives.
Past performance
To make an informed choice, examine the mutual fund's past performance over the last 5 to 10 years. This helps assess the fund's consistency and reliability. Also, compare its historical returns with its benchmark and other similar funds to determine how well it has performed.
Investment duration
Consider the investment duration of the funds. Be aware that they come with varying maturity periods, ranging from short-term to long-term. Try to match the fund’s maturity period with your investment timeline and return expectations.
Risks
It must be noted that several risks are associated with fixed-income mutual funds, such as interest rate risk, credit risk, and liquidity risk.Despite their stable returns, these risks can affect your investment and may reduce the overall returns provided by them.
Costs
Check the expense ratio of the fund, which is the cost of managing the fund. A lower expense ratio means higher net returns for you, as less of your investment is consumed by fees.
Disadvantages of fixed income funds
While fixed income funds offer various benefits, they also come with several disadvantages.
Lower returns
One significant drawback is that fixed income funds typically provide lower returns compared to equity investments. This limitation may hinder wealth accumulation over the long term, especially in a low-interest-rate environment.
Interest rate risk
Fixed income funds are subject to interest rate risk; when interest rates rise, the value of existing bonds falls. This volatility can negatively impact fund performance, particularly for long-duration bonds.
Inflation risk
Inflation poses another challenge, as it erodes purchasing power. If the returns on fixed income investments do not outpace inflation, investors may experience a decrease in real returns, affecting their long-term financial goals.
Credit risk
Additionally, there is credit risk, which arises from the possibility of default by bond issuers. Investing in lower-rated bonds may lead to higher yields but increases the potential for loss.
Limited liquidity
Lastly, some fixed income funds may have limited liquidity, making it difficult for investors to quickly access their money without incurring penalties or losses.
Conclusion
Fixed-income mutual funds are a great moderate-risk investment option for investors looking for a stable source of income. These funds are actively managed by professionals with decades of experience, making them suitable for both beginner and experienced investors alike.
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