What are fixed-income mutual funds and who should invest in them?

Fixed income mutual funds, also known as debt mutual funds, invest in fixed-income securities such as government bonds, corporate bonds, debentures, and money market instruments. They entail lesser risk than equity investments while offering relatively stable return potential – often higher than that of traditional savings avenues such as bank accounts and bank deposits.

This article will help you understand how fixed income mutual funds work, their potential benefits, and associated risks, to help you make informed investment decisions.

• Table of contents

1. Understanding fixed income funds
2. How Do Fixed Income Funds Work?
3. Types of fixed income funds
4. Features and benefits of fixed income mutual funds
5. Why Invest in Fixed Income Funds?
6. Taxation on fixed-income mutual funds
7. Factors to consider before investing in fixed income mutual funds
8. How to Invest in Fixed Income Funds?

Understanding Fixed Income Funds

A fixed income mutual fund invests primarily in fixed income or debt securities. These can include corporate bonds, government bonds, municipal bonds, Treasury Bills, commercial paper, certificates of deposit and repurchase agreements, among others. They are known as debt securities because they represent a loan given by the investor to the corporation or the government. In return, the investor seeks to get periodic interest payments along with the principal repayment at maturity.

The returns generated by these funds stem primarily from the interest payments on the underlying securities in a portfolio. Additionally, the market value of these securities may also go up or down in the secondary market, reflected in the fund’s Net Asset Value (NAV). This makes debt funds relatively stable and less risky than equity investments.

How Do Fixed Income Funds Work?

Fixed-income funds pool money from various investors to invest in debt securities. These funds generate return potential in two primary ways:

1. Interest payments: Interest income earned from the bonds and securities held in the portfolio. If paid on schedule, these can potentiall yield regular income.

2. Capital appreciation: Potential increase in the value of the bonds in the secondary market due to favorable market conditions.

However, provide greater flexibility, liquidity, and the potential for higher returns over the long term compared to traditional FDs.

Types of Fixed Income Funds

Fixed income mutual funds in India are categorised based on the duration and types of debt instruments they invest in. The categories include:

1. Overnight funds invest in securities with a maturity of one day.
2. Liquid funds invest in debt instruments with a maturity of up to 91 days.
3. Banking and PSU mutual funds invest predominantly in debt instruments of banks, public sector undertakings and public financial institutions.
4. Constant maturity gilt fund invests in government securities with a fixed maturity, typically 10 years
5. Ultra short duration funds invest in debt instruments with a Macaulay duration of 3 to 6 months. Macaulay duration measures the time it will take for the principal of a bond to be repaid from the internal cash flows generated by the bond.
6. Low duration funds invest in debt instruments with a Macaulay duration of 6 to 12 months.
7. Money market funds invest in money market instruments with a maturity of up to 1 year.
8. Short duration funds invest in debt instruments with a Macaulay duration of 1 to 3 years.
9. Medium duration funds invest in debt instruments with a Macaulay duration of 3 to 4 years.
10. Long duration funds invest in debt instruments with a Macaulay duration greater than 7 years.
11. Dynamic bond funds invest across durations based on interest rate outlook.
12. Corporate bond funds invest primarily in high-rated corporate bonds.
13. Gilt funds invest primarily in government securities across different maturities.

Features and Benefits of Fixed Income Mutual Funds

Some of the key advantages fixed income mutual funds that can make them appealing to a diverse group of investors are:

• Return potential: Debt mutual funds can offer the potential for higher returns compared to bank accounts. Longer duration debt funds can offer return potential that is comparable or higher than that of fixed deposits and other traditional avenues such as public provident funds.
• Multiple options:Fixed income mutual funds cater to a wide spectrum of investment needs and risk profiles. Categories such as overnight funds, liquid funds and money market funds can be suitable for short-term goals, offering high liquidity and low/low-to-moderate risk. Gilt funds, corporate bond funds, medium duration funds and long duration funds can be suitable for medium-to-long investment horizons.
• Professional management: These funds are overseen by seasoned fund managers equipped with the expertise to navigate the complexities of the fixed income market. These investment professionals meticulously design and manage the fund's portfolio, striving to optimise returns while mitigating risk.
• Liquidity: Fixed income mutual funds provide investors with the flexibility to buy and sell units with relative ease. This liquidity allows investors to access their capital when needed, subject to potential exit loads and other applicable expenses.
• Diversification: By investing in a basket of debt securities with varying credit ratings and maturities, fixed income mutual funds diversify their portfolios, thereby reducing the risk.
• Relative stability of capital:The relatively stable nature of these funds makes them suitable for risk-averse investors or those seeking to balance their equity investments with less volatile assets.
• Potential for steady income: The periodic interest payments generated by the underlying debt securities provide investors with a potentially steady income stream. This feature can be particularly attractive for retirees or individuals seeking a supplementary source of income to support their financial goals or lifestyle.
• Investment options: Just as with equity funds, you can leverage Systematic Investment Plans (SIPs) to invest in fixed income funds in a disciplined and regular manner. This approach can help you potentially build wealth over time through affordable investments.
• Potential for capital appreciation: Debt funds can offer the potential for some capital appreciation, though to a less degree than equity funds. Capital appreciation can happen when the market value of the underlying securities rises in the secondary market, which can happen when interest rates fall.

Why Invest in Fixed Income Funds?

Fixed income funds can offer the following advantages to investors:

1. Flexibility: Debt funds offer flexibility in investment strategies. For instance, you can invest in a lumpsum, or in regular instalments through a Systematic Investment Plan (SIP). You can even opt for a Systematic Transfer Plan (STP), so regularly transfer money from relatively stable debt funds to equity funds with high risk and high return potential. This allows for a more strategic approach to equity investments that mitigates market timing risk by spreading the investment over time.

2. Potential for stable income: Debt funds can provide stable income through interest payments from bonds and debentures. However, this depends upon whether the debtor pays their interests on schedule. Additionally, they offer the potential for capital appreciation if interest rates decline.

3. Liquidity: Unlike fixed deposits, open-ended debt funds have no lock-in periods. You can redeem your investments on any business day. However, there may be a nominal exit load applicable for the first few months or one year, depending on the scheme type.

4. Portfolio diversification: By incorporating debt funds into your investment portfolio, you can diversify your holdings and reduce overall risk, especially if you have a significant portion of your portfolio invested in volatile equity funds.

Taxation on Fixed Income Mutual Funds

The tax liability for fixed income mutual funds arises only when you redeem your units. For units purchased after April 1, 2023, capital gains are added to the annual income of the investor and taxed as per their prevailing tax slab.

Factors to Consider Before Investing in Fixed Income Mutual Funds

Before venturing into the realm of fixed income mutual funds, a prudent investor must carefully evaluate the following factors:

• Alignment with financial objectives: The first step involves a clear understanding of your financial aspirations. Are you seeking relatively stable growth or significant wealth-building potential? For the latter, equity funds may be more suitable.
• Investment horizon: Fixed income funds are usually suitable for short or medium-term goals where relative stability of capital is important. For a longer investment horizon or those seeking inflation-beating return potential in the long term, equity funds may be a better option.
• Risk appetite: While they typically carry less risk than equity funds, debt funds are not risk-free. Interest rate fluctuations, credit risk, and liquidity risk can all impact their performance and returns are not fixed or guaranteed.

Interest rate risk is the possibility that changes in interest rates will negatively impact the value of the fund's underlying securities. When interest rates rise, the prices of existing bonds typically fall, leading to a decrease in the fund's NAV. Credit risk is the risk that a borrower or issuer of a debt security will default on their obligation to repay principal or interest, potentially leading to a loss for the investor. Liquidity risk, meanwhile, is the risk that the fund may not be able to quickly buy or sell holdings without a drop in their market price.

Different debt fund categories entail different risk levels. Generally, the longer the underlying duration of the fund, the higher the risk involved. Therefore, some debt funds may carry low risk, while others may involve moderate risk.

How to Invest in Fixed Income Funds?

To invest in fixed income funds, follow these steps:

1.Assess your goals and risk appetite: Consider these factors when determining the fixed income fund category that is suitable for you. For short-term goals or to build an emergency corpus, low/low-to-moderate risk avenues such as overnight or liquid funds may be suitable. For medium-to-long horizons, corporate bond funds, gilt funds, banking and PSU funds, among others, may offer more return potential.

2.Select a mutual fund company: Once you have decided the scheme category, select an Asset Management Company. You may assess the historical returns*, fund manager’s track record and expense ratio to decide. *Past performance may or may not be sustained in the future.

3.Decide your investment route and amount: Depending upon your investing capacity and horizon, choose between lumpsum and SIP and decide your investment amount.

4.Initiate the investment: Invest directly through the AMC or through a registered distributor/aggregator, among other avenues. You can invest either online or offline.

FAQs

What are fixed income mutual funds?

Fixed income mutual funds are investment funds that primarily invest in assets like government and corporate bonds, offering regular income and moderate growth.

Are there any risks associated with investing in fixed income funds?

Although relatively stable, some risks associated with these funds include interest rate risk, credit risk, and inflation risk, which can impact the performance and returns.

How does SIP work with fixed income mutual funds?

SIP in fixed income funds allows investors to invest a fixed amount regularly, offering a disciplined and cost-effective way to build wealth over time.

Is a fixed-income mutual fund a good investment option?

Fixed income mutual funds can be a suitable investment avenue for individuals seeking relative stability along with potential for modest returns and regular income. It can also benefit investors seeking to diversify their portfolio and balance equity investments with less volatile assets.

Do fixed income mutual funds have risks?

While generally considered less risky than equity funds, fixed income mutual funds are not risk-free. They are subject to interest rate risk (the chance that a change in interest rates will have a corresponding effect on bond prices), credit risk (the risk of default by the issuer of the underlying debt securities), and liquidity risk (the potential difficulty in selling units at a fair price).

What is the difference between fixed income mutual funds and equity mutual funds?

Fixed income mutual funds primarily invest in debt securities like bonds and government securities, aiming to generate income through interest payments. Equity mutual funds, on the other hand, invest in stocks of companies, with the primary objective of capital appreciation over the long term. Equity funds are generally considered more volatile than fixed income funds but also have the potential for higher long term returns.

How to select a fixed income mutual fund?

Selecting the right fixed income mutual fund involves considering your financial goals, risk tolerance and investment horizon. Debt funds with short maturities are relatively less risky than those with longer maturity profiles.

Is the option of SIP available in fixed-income mutual funds?

Yes, Systematic Investment Plans (SIPs) are available for fixed income mutual funds. Just as with equity funds, SIPs allow you to invest a fixed amount at regular intervals, enabling disciplined investing and rupee cost averaging.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.