Be aware of Income funds

Ever since the trend of rising interest rates started in mid-2003, income funds have moved out of investors' radar and have been replaced by short term, floating rate, fixed maturity and liquid funds.

The reason is obvious: income funds have been the worst performers over the last one and three years giving returns of just 4.24 and 3.14 per cent a year, respectively (Value Research).

Keeping them company at the bottom are medium and long-term gilts, which have given returns of 4.49 and 4.09 per cent over the same period. Liquid and short-term funds in comparison have given returns of nearly 6 per cent in the one-year period. Should investors ignore income funds and focus instead on short-term funds?

Investment options

Three months ago it would have made more sense to not invest in income funds, as interest rates were peaking.

However, yields on the ten-year benchmark government security have fallen, which has boosted the net asset values of income funds. But, with rates having come down, would investment in these be warranted?

There are votaries for both, short and long term funds, but in large parts it also depends on the investor's risk appetite, investment horizon and other investment options.

Asks Ritesh Jain, fund manager, Kotak Mutual Fund, "With fixed deposits offering 8 per cent over a one year period, would investors wish to take on an interest rate risk for a 50-basis point incremental return from income funds?  Moreover, if interest rates go up, investors in income funds would have to reconcile to lower returns. With fixed deposits, they score only when the tax adjusted returns are taken into consideration."

With a tightening of liquidity due to the festival season, a possible hike in rates and volatility, an investment in income funds does not seem to have many takers.

Horizon and returns

While there is a lack of clarity on which way interest rates would move, on the longer term they will average out over a longer period.

Says Devendra Nevgi, head of fixed income at Quantum Mutual Fund, "Interest rate cycles last for three to five years and you need this time frame to catch a rate rally."

Over the long term, income funds tend to generate better returns than short-term funds. Over a five-year period, category returns have been 7.11 per cent as compared to 5.73 per cent for shorter tenure funds.

"Over a five-year period you can expect a return of 8-12 per cent," says Sandeep Bagla, head, fixed income Principal PNB Asset Management.

And it is not just on the returns front that income funds score. "They not only give a better risk adjusted return as compared to other risky and volatile asset classes, but also serve as a partial hedge against inflation," says Nevgi.

Investments in these funds, suggests Nevgi, should be done at the peak of the interest rate cycle. While that is ideal, one is not sure of where the rates will move.

"Systematic investment plans are a good way of capturing growth instead of committing upfront. If rates move above 8.25 per cent, you could look at a larger one-time investment in these funds," says Bagla. If interest rates do not dramatically move up, do fund managers have the flexibility to make hefty gains?

Trading gains

Income funds are primarily invested in bonds, debentures, government securities and short-term instruments like commercial papers and repos. The regular income for these funds comes from coupon payments and the trading gains accrue from interest rate movements.

Typically, today, between 50-70 per cent is invested in CPs/CDs of a one-year maturity giving a return of 7 to 8 per cent (fixed component), while the rest is parked in government securities over varying tenures.

Kotak's Jain says, "The kicker for these funds comes from the 30 per cent cash component that is invested in gilts and gains from interest rate movements."

With volumes and liquidity in gilts showing a sudden jump, trading profits could start making an impact on returns. And with corporates likely to tap the debt market to finance expansion, opportunities in the bond market will only increase. Since AAA-rated paper are more risky than gilts, they offer higher yield than gilts.

Hike may happen

With RBI's goals of containing inflation, credit growth and money supply, it is likely that a hike may be in the offing.

With credit growth at 29 per cent year-on-year instead of 20 per cent as of September 2006 and showing no signs of slowing down, money supply growth at 19 per cent instead of RBI's 16 per cent target and consumer demand led inflation likely to be over 6 per cent, a hike might be around the corner.

Unless you can stomach volatility, do not mind a longer waiting period, you are better off parking your funds in shorter tenure funds.

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