Income Funds & Fixed Income Trusts

An income fund (also called a fixed income fund or bond fund) is a unit trust that lends money to the government, banks, and companies for longer periods than a money market fund does. Lending for longer generally earns a higher return, which is the whole point of an income fund.

It is the natural next step up from a money market fund: a little more return, in exchange for a little more movement in your investment's value.

What it invests in

Income funds hold longer-tenure rupee debt, such as:

• Treasury bonds: longer-term government securities (often several years to maturity).
• Corporate debentures and securitised paper from listed and rated companies.
• Longer-term fixed deposits with licensed banks and finance companies.

Where a money market fund's holdings nearly all mature within a few months, a large share of an income fund's holdings can mature more than a year out. Some specialist "gilt" income funds hold only government securities, which removes most credit risk but leaves the fund more sensitive to interest-rate moves.

The two risks to understand

An income fund carries two risks that a money market fund largely avoids:

1. Interest-rate risk. The value of an existing bond moves opposite to interest rates. When market rates rise, older bonds paying lower rates are worth less, so the fund's unit price can dip. When rates fall, those bonds gain value and the unit price rises. The longer the debt the fund holds, the bigger these swings.

2. Credit risk. If a company or institution the fund has lent to fails to repay, the fund loses money. Managers limit this by lending to higher-rated borrowers and spreading the money across many issuers.

More return, more movement

Because of interest-rate risk, an income fund's returns are less smooth than a money market fund's. In years when rates fall sharply, income funds can post unusually high returns; when rates rise, returns can be muted or briefly negative. Over a medium-term horizon, the aim is a higher average return than cash or a money market fund.

Like all unit trusts, income funds are not bank deposits and are not covered by the Sri Lanka Deposit Insurance Scheme.

Who it suits

Income funds suit investors with a medium-term horizon (a few years) who want a higher return than a money market fund and can accept some ups and downs in value along the way. They are a common middle ground between cash-like money market funds and the higher risk of equity funds.