Wednesday, 16 October 2013

Why you don’t make money from Income Funds

The last few weeks have been extremely turbulent and volatile for the financial markets - stock markets have been moving up and down in crazy frenzy moves, bond yields have been galloping upwards resulting in falling bond prices, precious metals (gold and silver) hitting new multi-year lows while the Indian rupee hitting all time life time lows. The striking of them all is the realization to many a fund investors that they have lost money in Income / Debt / Bond Funds. Yes, it’s very difficult for a fixed income investor to digest the fact of losing his capital.

You don’t make money from Income Funds because of:

Interest Rate Risks
Although the name is Fixed Income securities, there are different types of risks while investing in them like credit risks, interest rate risks, yield curve risks, liquidity risks and basis risks. A very misunderstood, formidable, unquantifiable and underrated risk is “interest rate risk”. This risk is directly related with the maturity of a security – the longer the maturity the higher the risk (and return). For long dated fixed income securities, when interest rates increase the price of the bond decreases and vice versa. Therefore, if you invest in Income Funds during an increasing interest rate environment then the value of the fund is likely to depreciate.

Absurd outdated advise from Fund Advisors
Investments in income funds should ideally be done when the interest rates are high because of dual factors – firstly, the inherent yield of the income fund would be elevated which will ensure high accrual income and secondly, if interest rates are currently high then other things remaining constant, there is more likelihood of it going down in the future. However, unfortunately income funds are generally not marketed when interest rates are high but are actually promoted when interest rates have already moved down because when interest rates have already softened in the near past, the return from Income Funds would be unsustainably super normal which would look further bloated when it is incorrectly annualized.   

Fund Manager Bias
Any fund manager hates when his fund underperforms. And the fund manager would certainly not like when there is negative return on a debt product like an Income Fund. Hence, during an increasing interest rate environment, the fund manager would unjustifiably reduce the maturity of the fund and start managing an income fund like a short term plan going against the very mandate of the fund itself.

Poor Performance does not come cheap
Income Funds are nothing but interest yielding debt products. But, when someone deducts high fees from the interest rate then what would happen – substantial fall in the income yields. That is what happens with Income Funds which are loaded with high fund management expenses. After all, poor performance does not come cheap!


There are some distinct advantages of investing in Income Funds like tax arbitrage since return on growth funds is treated as capital gains as compared to interest income in the case of bank fixed deposits and hence subject to lower tax rates along with indexation benefits, a chance to ride the interest rate cycle, invest in GSecs etc. However, your success with Income Funds, like any other investment would depend on dual factors. Firstly, the entry point of your investment – timing is very important while investing in Income Funds, if you invest just before an increasing interest rate cycle then unfortunately it would take many months or even couple of years to regain by way of interest accrual the capital which you might have lost. Secondly the exit point, Income Fund like any other product is not an investment for the long term, once you ride the downward shift in the yield curve, it is time to pack your bags, book your profits and get out of it.

To conclude, learn to ride the interest rate curve earning above normal profits from your Income Fund investments and not allow the fund manager or advisor to have a ride with your money.