Many of you feel that investing in bonds is unattractive. The argument is simple: If you can take the risk, why not invest in equity, as it typically offers higher returns than bonds! While the argument may appear logical, you will be doing a lot of harm to your financial health if you do not invest in bonds! In this article, we will show you why you should invest in bonds. Importantly, we show you when you can consider buying immediate annuities as a part-substitute for bond investment in your retirement portfolio.
Bonds available for retail investment have two important features. One, they have a finite life. And two, they have certain cash flows. Both these features help you in meeting your investment objectives. How?
Suppose you want to buy a house three years hence. It is risky to invest in equity today to accumulate the wealth that you require to buy the house three years hence. What if equity prices decline a year after you invest? Will you be able to recover the losses and earn the returns required to make the down payment for the house?
Investing in bonds, on the other hand, provides stable and certain flows. You can, for instance, invest in a three-year cumulative fixed deposit with a bank. On maturity, you are certain to receive your initial capital plus the accumulated interest. You should, in fact, invest only in bank fixed deposits when your investment horizon is 5 years or less.
What if your investment horizon is more than 5 years? Even if equity prices decline closer to the date when you want to withdraw the money, you can achieve a significant proportion of your investment objective if you have bonds in your portfolio. Bonds are, therefore, an important component of your investment portfolio. Bond investments that typically suit your requirement are bank fixed deposits and tax-free bonds offered by government companies such as IRFC and NHAI.
You can also consider buying immediate annuity from insurance companies as part-substitute for your bond investments. For the purpose of discussion only and not as a recommendation, we will use LIC’s Jeevan Akshay plan. You have to pay a lump-sum amount to LIC to purchase the annuity. LIC will pay a fixed sum of money till either you or your spouse survives. And if you choose, LIC will also return the purchase price to your children after the annuity payment stops.
Suppose you are 50 years old. LIC will pay you Rs 6,930 for every Rs 1 lakh of purchase price. Since you will be working and do not need this income immediately, you can reinvest this amount every year till you retire. Assuming you retire at 60, you would have reinvested the yearly annuity payment for 10 years.
You would have noticed that the pre-tax return from the annuity is only 6.93 per cent; that is significantly lower than 8 per cent you can earn if you invest in a 10-year bank deposit. But assume you live till 80. This means you have to renew your bank deposits thrice between 50 and 80. And at each of these renewal dates, if interest rates decline substantially, you will be forced to renew at a lower rate. Besides, at old age when your cognitive abilities are failing, it is quite an ordeal to remember to renew your deposits!
You can consider immediate annuities as a life-long fixed deposit. It can be, hence, used as part-substitute for your bond investments. You can allocate not more than 25 per cent of your bond investments for such annuities in your retirement portfolio. Our back-of-the-envelope calculation suggests that buying immediate annuities would be meaningful to you if you are between 40 and 50 years.
(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor learning solutions. He can be reached at firstname.lastname@example.org)