Bonds are the best form of investment if you have enough capital to meet your life goals. If not, you could have bonds as your anchor portfolio and use equity to bridge any shortfall in your desired wealth. Here we discuss why bonds can be your anchor portfolio and why you should not use them to generate upside or excess returns.

Bonds as anchor portfolio

You know at the time of investment the cash flows you will receive at maturity. This certainty helps you achieve your life goals. Suppose you need ₹10 lakh in three years to meet certain expenses.

If a three-year bank fixed deposit pays 9 per cent per annum taxable interest compounded annually, you have to invest ₹8.32 lakh today to receive ₹10 lakh in three years. And unless the bank defaults, you are certain to receive the cash flows even if interest rate changes during this period.

This benefit exists only if you invest directly and not through a mutual fund! Why? A bond fund’s net asset value is marked to market. That means you are exposed to the market risk, namely, your investments will decline in value if interest rate increases.

But you will face capital constraints if you choose bonds as your only investment asset. Why? Bonds carry lower post-tax return compared with other avenues such as equities. Therefore, in a bond-only portfolio, you need larger capital to meet your life goal.

Upside potential

You should not look to bonds to generate upside potential. If bonds form your anchor portfolio, then you should favour assets that offer high upside potential to bridge the gap, even if the associated risks are higher.

Now, bonds typically offer fixed cash flows till maturity and, hence, have limited upside.

According to the Morningstar website, while bond funds generated about 8 per cent annualised return in the last five and 10 years, many equity funds generated higher than 15 per cent.

Data on the constituents of a bond index are not easily available because it is created by service providers such as CRISIL for asset management firms.

So, how can you measure whether a bond fund is generating alpha, which is the excess returns over an appropriate benchmark?

Conclusion

You can build your portfolio primarily with bonds and use equity investments to bridge the gap.

Suppose you need ₹1 crore after 10 years to fund your child’s education, but want to ensure ₹60 lakh at the minimum. You should invest in 10-year bonds so that the maturity value of your investment is ₹60 lakh. The rest of your savings earmarked for education expenses should be invested in equity to bridge the ₹40-lakh gap.

We call this the threshold value method (you can also read about this in ‘Knowledge Arbitrage’ dated July 15, 2012).

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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