Turn towards income funds

ET 1/2/09

 

If you’ve ever spent a few hours waiting outside an ICU, then you know what it is like when the doctor comes out with the news that a critically ill patient is making progress. The assurance comes like a ray of light that you desperately latch on to as you follow up with questions about what can be done to further improve the patient’s condition. In moments of uncertainty, a reassurance carries a significance that is unparalleled in ordinary circumstances.

 

If you extend this analogy to the stock market, you can see how the demand for assured return instruments such as gilt funds and income funds has soared in the last few months. But even within these asset classes, experts feel income funds stand to give the investor benefits which exceed those given by gilt funds, which are being touted as the best option by most asset management firms. SundayET explains why an individual should increasingly turn towards income funds. 

Before getting into the facts of the case, you need to know the fundamental difference in the way that income funds and gilt funds work. A gilt fund is one, which predominantly invests in government securities such as Central government dated securities, state government securities and treasury bills. The yield from government securities is currently hovering below 6%.

Meanwhile, in an income fund, the investment is made in a both government and corporate securities such as bonds, debentures, certificates of deposits and so on. While the government securities offer an element of safety to the fund, the corporate securities currently have comparatively higher yields. “Moreover, as income funds invest both in the gilt and corporate bonds, it also gives the benefit of diversification of both the asset classes,” says Sandesh Kirkire, CEO of Kotak Mahindra Asset Management Company.

The difference between income funds and gilt funds becomes all the more important in the current situation. Explaining this, Santosh Kamath, CIO (fixed income) of Franklin Templeton Investments, says, “The aggressive monetary easing and fall in inflation has led to a sharp decline in gilt yields. Moreover, given the quantum of rate cuts and liquidity injections announced so far, the pace of monetary easing is expected to slow.”

The lowering of interest rates assumes even more significance because interest rates are known to have an inverse relation with bond prices. As interest rates soften, the yield of the bonds decrease , but the price tends to increase. When bond prices rise, this is reflected in a rise in the net asset value (NAV) of income funds. “Meanwhile, a favourable turn in the economy could hamper the returns offered by gilt funds,” says Dhirendra Kumar, chief executive at Value Research.

On the performance front, gilt funds have performed better than income funds in the last six months. The average return for the last six months from top five gilt funds was 30% against 19% generated by top five income funds.

However, the difference between the returns from these categories is quickly coming down. In the last one-week , income funds have outperformed gilt funds.

Choosing between a gilt fund and an income funds, however , will strictly depend on the kind of investor you are. There is almost no credit risk associated with gilt funds and hence they are deemed appropriate for conservative investors.

“Those willing to take interest rate risk can look at income funds and the typical investment horizon should be between 1-2 years,” says Kamath. Which means that an investor should look at investing in a short-term income fund at the moment rather than one which is long-term .

While choosing which income fund to go for, there are a couple of things that you need to keep in mind. It is absolutely important to look at the portfolio of the fund and the ratings of the certificates on which the fund manager is putting money. The reputation of the bond issuer is of critical importance in this case. Also keep a look-out for recent changes that have been taken place in the fund.

You should also be comfortable with your fund manager and the style risk that you going to take. Remember to do a background check on the performance of the funds managed by that particular fund manager. The performance track record of the fund must also be aligned with your expectations. Funds have the tendency to perform better during good times but fail to show a decent performance during tough times. Hence, try to pick a fund, which has maintained a consistent performance, during both good and bad times.

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