Why you don't make money from income funds?

Mehrab Irani
Tata Investment Corporation

The last few weeks have been extremely turbulent and volatile for the Indian 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.

Also Read: Here's how you can use EPF for urgent cash requirements

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 that he has lost all his capital after all losing capital is the right of investors investing in risky assets like equity, commodities or real estate and not on those investments which generate "fixed" returns! But, the irony of the fact is that most gullible investors have been caught unawares as they watch their capital wipe out of their Income Funds. So, let us make an attempt to answer this tricky but intriguing question why don't you make money from Income Funds.

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 fixed income securities. The major type of risks associated with fixed income securities are credit risks, interest rate risks, yield curve risks, liquidity risks and basis risks.

The most common risks which an investor attaches to fixed income investments is credit risk. However, there is an equally formidable, unquantifiable and underrated risk while investing in fixed income securities Interest Rate Risk.

Few people understand this risk. For example, a long term Government of India Security (GSec) may have zero credit risk (because the Government can literally "print notes" and pay back the loan), but the long dated GSecs have one of the highest interest rate risks. Interest rate risk is directly related with the maturity of a security the longer the maturity the higher the risk (and return). In short, for long dated fixed income securities, when interest rates increase the price of the bond decreases and vice versa.

And remember that predicting the cash flows of an individual company might be easy but predicting the movement of interest rates is not a difficult but an impossible task which the Government, RBI, fund managers, economists, analysts etc try to do but with no real success it's just an intelligent guess. 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

One very important factor in investments is the reversion to mean whether it is a country, economy, company or human being the law of averages catches up with everyone if someone is able to sustain during bad times then it is surely going to enjoy the good times.

Interest rate also reverts back to mean. Therefore, 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 high 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 never marketed when interest rates are high or moving up.

Infact, income funds are widely promoted when interest rates have already moved down. This is because of faulty outdated advise from fund advisors. The reason is very simple when interest rates have already moved down in the near past, the return from Income Funds would be unsustainably super normal.

This high untenable return is then projected as the likely future performance of the fund and sold along with the notion of "safety of capital".

And mind you, the returns shown are "annualized retunrs" I fail to understand that how can someone annualize the return of a market related product, it can be done only in the case of an accrual product. For example, if say the stock index goes up by 2% in one day then can by any stretch of imagination someone just annualize it and say the annual expected return on it would be 730%! Certainly not.

But then this is done and an accepted norm for marketing Income Funds to the innocent unsuspecting investor.

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 just reduce the maturity of the fund and start managing an income fund like a short term plan. But, that was not the objective of the fund.

That was the view of the investor when the investor wants to take interest rate risk and entrusts his money to the fund manager then who is he to take the call on behalf of the investor. And the worst of them are dynamic funds which give the right to the fund manager to increase or reduce the maturity of the fund based on his interest rate outlook.

Needless to say, predicting interest rates is a risky bet in which most of the fund managers miserably fail leading to substantial lost of investor money and trust.

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!

Conclusion

So what does it mean? You should not invest in Income Funds. Would these funds never make money for you. Certainly not. Successful investing is anticipating the anticipations of others and we are right to be unduly interested in discovering what average opinion believes average opinion to be.

Remember, every dog has its day and so does every investment product. 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 a increasing interest rate cycle then unfortunately it would take many months or even couple of years to regain by way of interest accrual the money which you might have lost in accrual.

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 and if you fail to exit at the right time falsely believing the so called expert advise of investing for the long term then remember what advice the great economist Mr. John Maynard Keynes had to offer, "in the long run we are all dead" and so will be the faith of your Income Fund investment if you think to stick with it for the long haul.

To conclude, you 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.