What Are Fixed Income Mutual Funds?

13 Apr 2021|

6 min read |

by ICICI Securities Team

When you start investing in mutual funds for the first time, you will find that there are various kinds and categories – from equity and debt funds to hybrid and solution oriented schemes funds. Most people typically invest in equity and debt mutual funds. Debt funds, also known as fixed income funds, are becoming increasingly popular. Let’s find out what they are.

What Are Fixed Income Mutual Funds?

Fixed income or debt mutual funds are those that focus on investment instruments which pay a fixed or set returns rate. The objective of this category of mutual funds is to provide investors with stable returns. The idea behind this investment is to create a fund portfolio that generates income through interest payment and capital gains which is passed on to the investor. The amount you receive from these funds primarily depends on your mutual funds’ performance.

Like all other mutual fund schemes, these funds are also managed by professional fund managers by pooling resources from various investors. As per SEBI categorisation, there are 16 categories of debt funds. They are as under:

Overnight Funds

Overnight Funds are open-ended debt schemes that invest in overnight securities having maturity of 1 day.

Liquid Funds

Like Overnight funds, Liquid Funds are also open-ended, fixed income funds. These funds invest in both debt and money market securities having a short maturity period of upto 91 days only.

Ultra-Short Duration Funds

Ultra-Short Duration Funds invest in debt and money market instruments such that the Macaulay duration of the investment portfolio is between 3 and 6 months. Macaulay duration is the time an investor would take to get back all his invested money in the bond by way of periodic interest as well as principal repayments. These are also open-ended debt schemes.

Low Duration Funds

Low Duration debt funds invest in debt as well as money market securities such that the Macaulay duration of the investment portfolio is between 6 months and 1 year. Like Ultra Short Duration funds, low duration funds are also open-ended, short duration schemes.

Money Market Funds

Money Market Funds are open-ended debt schemes that invest in money market instruments having maturity upto 1 year.

Short Duration Funds

Short Duration Funds invest in debt and money market instruments such that the Macaulay duration of the investment portfolio is between 1 and 3 years. Like all other short duration fund categories, these funds are also open-ended debt schemes.

Medium Duration Funds

Medium Duration Funds are open-ended medium-term debt schemes. They invest in debt and money market instruments. Here, the Macaulay duration of the investment portfolio is between 3 and 4 years.

Medium to Long Duration Funds

Medium to Long Duration Funds are also open-ended debt schemes, which invest in debt and money market instruments. For these debt fixed income schemes, the Macaulay duration of the investment portfolio is between 4 and 7 years.

Long Duration Funds

Yet another open-ended debt fund scheme, long duration funds, like all other debt funds mentioned above, invest in debt and money market securities. The only difference here is that the Macaulay duration of the investment portfolio is more than 7 years

Dynamic Bond Funds

A Dynamic Bond Fund is an open-ended fixed income scheme, which does not come with any predetermined investment portfolio duration. Fund can invest across any durations of their preference as per the market.

Corporate Bond Funds

The Corporate Bond Fund open-ended scheme invests approximately 80% of the total assets in some of the highest rated corporate bonds.

Credit Risk Funds

The Credit Risk Fund open-ended scheme invests approximately 65% of the total assets in the below-highest rated corporate bonds.

Banking and PSU Funds

This open-ended debt Fund scheme invests approximately 80% of its total assets in debt securities of entities such as banks, public financial institutions, public sector undertakings and so on.

Gilt Funds

The Gilt fund is yet another open-ended debt fund scheme with no specific maturity period. It invests approximately 80% of its total assets in various types of government securities.

Gilt Fund with 10-year Constant Duration

A gilt-fund with specific investment duration, this fixed income scheme invests 80% of its total assets in various types of government securities such that the investment portfolio’s Macaulay duration is 10 years

Floater Fund

The last type of SEBI-categorised debt fund, the floater fund is an open-ended debt fund instrument, which predominantly invests in floating rate instruments. These funds invest approximately 65% of their total assets in various floating rate instruments. These instruments do not offer fixed returns, unlike other debt instruments. The return is linked with some external benchmarks and can fluctuate due to a change in the benchmark.

Fixed-income mutual funds, which have a short Macaulay duration, are the ideal investment instruments for conservative investors looking for steady income sources. Pensioners and retired people, for instance, can benefit from investing in these low-risk mutual funds, which also offer high liquidity.

Features of Fixed Income Mutual Funds

The funds pool your money with others to primarily invest in bonds. Here's why they might suit you well:

Steady Income: Receive regular interest from the bonds in the fund's portfolio.
Less Volatility: Much less price swing compared to equities; hence, considerably smoothing the ride.
Diversification Power: By investing in a diversified portfolio of bonds, each with its level of risks
Professionals at the Wheel: Seasoned fund managers who can take care of the picks
Tax Advantages: Likely to pay less in taxes on your gains than any other investment.

Factors to Consider Before Investing in Fixed Income Mutual Funds

Interest Rates: Rising interest rates will reduce bond prices. Understand, of course, how interest rate movements can impact your investment.
Credit Risks Note the credit rating of bonds in your fund. The higher the rating, the lesser the chance of a default.
Duration: The higher the duration, the more the funds swing with every movement in interest rates. In general, shorter durations are safer.
Yield: The higher the yield, usually the greater the risk.
Fees: Do not forget to know about the management fees and other levies that may chomp into your returns.
Investment Goals: The fund must align with your financial goals and risk appetite.

Why Invest in Fixed Income Mutual Funds?

Stable Return: Unlike equities, fixed-income funds have more stable returns and are relatively less risky.
Diversification: They enable you to diversify your portfolio and, hence, bring down your overall risk by off-setting other volatile investments.
Regular Income: They pay interest regularly, which can turn out to be a steady source of income.
Preservation of Capital: This comes in very handy in preserving your capital, especially if you are nearing retirement or just need the money soon.
Professional Management: Since it is designed by professionals, they will choose and manage bonds for you. It saves you time and effort.
Liquidity: The ease of buying and selling confers flexibility when one needs access to money.

Tax Efficiency of Fixed Income Mutual Funds

Fixed-income mutual funds can enhance the tax efficiency of your portfolio. Here's how:

Lower Tax Rates: Long-term capital gains—held over a year—from bond funds are generally taxed at lower rates than income from dividends.
Tax-Advantaged Accounts: Now, hold these funds in IRAs or 401(k)s for tax-deferred or tax-free growth right through to maximize your returns.
Minimize Turnover: Whenever possible, invest in low-turnover funds to decrease purchases and sales. This approach reduces capital gains distributions, which are taxable.

Knowing these tax benefits makes your investments in fixed-income mutual funds much more strategic. You will be able to hold onto more of that hard-earned cash!

Fixed-Income Mutual Funds FAQs

Is a fixed-income mutual fund a good investment option

If you want to generate steady income at most, fixed-income mutual funds are the right one with lower risk. They pay regular interest and diversify your portfolio, but they might appreciate less in value than the stock would. Consider your goals—to see if they match!

Do fixed income mutual funds have risks?

Yes, even fixed-income funds come with some risks. An increase in interest rates can reduce the prices of bonds, and there is always a level of chance that the borrower may default or fail to return on the money owed. Look for funds that manage those risks to your comfort level.

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

Equities funds have the stated aim of growth through investment in stock. They can be pretty volatile, although the returns from time to time can also be very high. Fixed-income funds strive for stability and investing in bonds that give regular interest. They are usually less risky; though growth may also be lower.

How to select a fixed income mf?

This all depends on your goals when choosing a fixed income fund. A correct investment strategy takes into account the risk tolerance and the investment horizon. One puts their money in funds which have low expense ratios and a duration which is matched with one's investment time frame. The quality of credit will help a person minimize default risk, so research fully on that too.

How do fixed income mutual funds distribute returns?

Fixed income mutual funds distribute returns in the form of interest payments to investors, which is usually quarterly or annually. Interest is paid out to investors from the interest earned by the fund on its holdings of bonds.

Can I invest through SIPs in Fixed Income Funds?

Of course! A majority of funds, including fixed income mutual funds, offer the facility of investing through Systematic Investment Plans. It allows you to invest a fixed amount at regular intervals to build your portfolio gradually and averaging out costs over time

What is duration in debt fund?

Duration in a debt fund reflects how much the price of the fund changes because interest rates have changed. You can think of it like an average time you get back your money that is invested in that fund. Higher the duration, more volatile or bigger would the price swings when interest rates move up or down.

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