Income funds mainly focus on generating regular income for the investors by investing in high dividend-generating stocks, government securities, certificate of deposits, corporate bonds, money market instruments and debentures .
1. How do Income Funds work?
The NAV of an income fund is calculated up to 4 decimal points. Income funds attempt to deliver returns both in declining and rising interest rate scenarios by active management of the portfolio. They may follow either of the two strategies:
a. Generate interest income by holding the instruments until maturity. b. Manage gains by selling them in the debt market if the price of the instrument goes up high.The fund manager aims to deliver higher returns which have higher stability by allocating towards debt and money market instruments which are investment grade and have relatively low levels of interest rate riskHistorically, income funds have found to generate higher returns than conventional bank fixed deposits. Unlike the lock-in period in an FD, income funds offer greater flexibility of redemption and withdrawal.
2. Who should Invest in Income Fund?
Income funds are best suited for those investors who wish to have a regular and stable income. This type of fund carries less risk concerning default. For example, a person who retired from the job will need money for his day to day expenditure, will prefer income fund in comparison to all other funds. Conservative investors who want to earn better returns than their conventional havens may think of income funds.
Liquid funds are debt funds-
that invest in short‐term assets such as treasury bills, government securities, repos, certificates of deposit, or commercial paper. According to SEBI norms, liquid funds are only allowed to invest in debt and money market securities with maturities of up to 91 days.
The return of a liquid fund depends on the market price of the securities held by the fund. However, since prices of short‐term securities do not change as much as long term bonds, the returns of liquid funds are relatively more stable as compared to other debt funds
How do Liquid Funds Work??
To understand how liquid funds work, you need to know where they invest and how they generate returns.
- Where do Liquid Funds Invest:A liquid fund will typically hold securities that are short term, of good credit quality, and highly liquid. A recent set of guidelines issued by SEBI has helped to reinforce these fund features.
Liquid funds can invest only in listed commercial paper, and they have an overall exposure limit of 20% in a sector. They are not permitted to invest in risky assets as defined by SEBI norms. These norms aim to contain credit risk in the liquid fund portfolio.
Further, liquid funds must hold at least 20% of their assets in liquid products (cash and cash equivalents such as money market securities). This ensures that they can quickly meet any redemption demands.
- Sources of Earnings:Liquid funds earn mainly through interest payments on their debt holdings; a very small part of their income is generated via capital gains. This is a defining feature of liquid funds, so let us understand it in some detail.
When interest rates fall, bond prices go up. When interest rates rise, bond prices fall. The negative relation between bond prices and interest rates is stronger for long term bonds. This means that the longer the maturity of a bond, the more it responds to changes in market yields.
Since a liquid fund invests only in short term securities, it’s market value does not respond much when interest rates change in the market. This means that liquid funds do not have significant capital gains or losses. In a rising interest rate environment, liquid funds often outperform other debt fund because (i) their interest earnings are going up (ii) their market values suffer only to a limited extent due to capital losses. In market jargon, we say that liquid funds have a very low-interest rate risk.
Who Should Invest in Liquid Funds?
- Investors with a short investment horizon:Liquid funds are best suited for those with an investment horizon of up to 3 months, as the funds invest in securities with comparable maturities. Investors with longer investment horizons‐ say 6 months to a year‐ should invest in slightly longer duration funds (say ultra-short duration funds) so that they can earn higher returns.
- Investors who invest in bank deposits:Investors who keep their surplus funds in bank deposits can benefit from liquid funds on two fronts: greater withdrawal flexibility and better returns. In a traditional bank fixed deposit, funds are locked‐in for a fixed period; and an interest penalty is imposed on premature withdrawal. In contrast, liquid funds offer flexible holding periods with easy exit options. Money in bank savings accounts can be withdrawn at any time, but they offer around 3%‐4% interest only, which is lower than the 5% plus usually earned by a liquid fund.
- Investors who want to keep Contingency Funds:The purpose of liquid funds is to provide liquidity and safety while generating a low return. Hence investors can park an emergency or contingency corpus in a liquid fund, with the assurance that it will be safe and can be redeemed when necessary.
- Investors who need to Park Funds Temporarily:Liquid funds are cash management products that are designed to keep funds safe while earning a small return. Hence, a large sum of money, say, from a bonus or sale of property or inheritance, can be temporarily parked in a liquid fund until the investor decides how to invest the corpus.
- Medium to Route investments in Equity Funds:Investors can hold funds in a liquid fund and use an STP to route investments systematically into an equity fund. This enables them to invest in equity periodically, while at the same time, the corpus in the liquid fund earns stable returns.