If you had invested in stocks constituting the Nifty Index, your return in the last one year, including dividends, was about 5 per cent. It is, therefore, not surprising that many are increasingly leaning toward bonds as their primary investment avenue.

The question is, can you create a portfolio primarily with bonds and yet hope to achieve your objectives? In this article, we discuss a portfolio approach using bonds as your primary investment, with some equity for upside.

Why bonds? There are several reasons to invest in bonds. One, you receive stable cash flow from such investments; this helps in better planning.

Suppose you require ₹40 lakh to fund your child’s education 10 years hence. You can easily calculate the money you have to save every month in fixed deposits earning 9 per cent interest per annum to accumulate that amount in 10 years. The same cannot be said of your equity investments.

Two, tax-free offerings from government companies in recent times have made bond investments more attractive. The interest income is tax-free. Plus, you can invest in these bonds to match your longer term investment objectives.

That is, unlike fixed deposits, you can invest in these bonds when you have a 15- to 20-year investment horizon, as in the case of your retirement portfolio.

Three, you could derive greater satisfaction from your bond investments. Why? The return on investment is certain; you receive interest income on your deposits or bonds every year. Contrast this with equity, where the primary return is in the form of capital appreciation. And that depends entirely on the market.

You would have earned about 15 per cent between 2012 and 2013, but your returns would have been negative between 2011 and 2012. The feeling of regret is high, especially when equity returns are lower than bond returns.

Bond Floor? There are, indeed, compelling reasons to invest in bonds. Yet, you need equity in your portfolio. Why? Often, your required return or the minimum acceptable return (MAR) from your investment is more than the return you earn on fixed deposits. Bank fixed deposits earn a post-tax return of 6.3 per cent, assuming 30 per cent personal tax rate and tax-free bonds earn 9 per cent.

But what if your MAR is 11 per cent? You have to then invest in assets that offer a higher return to bridge the return-gap. Equity is one such investment.

Unfortunately, you have to invest significantly in equity to bridge the return gap. Suppose your initial capital is ₹10 lakh, MAR is 11 per cent and bond return is 9 per cent. The return-gap on bonds is 2 per cent (MAR less bond returns).

And here is the issue: you should invest about 65 per cent in equity to bridge the return-gap, assuming equity return of 12 per cent. If, however, you assume a 15 per cent return, you should invest about 35 per cent in equity.

Clearly, the proportion of equity investment in your portfolio depends on your return expectations. Importantly, it appears that you cannot expect to achieve your investment objectives if you use bonds as your primary investments. So, what should you do in case your MAR is greater than bond returns?

When to use what Fortunately, you can bridge the return-gap without investing significantly in equity. But that requires a cut in current consumption or an increase in income, or both.

You have to significantly increase your monthly savings to bridge the return-gap. This strategy of having bonds as your primary investment would work if your initial investment horizon is more than 10 years to benefit from compounding of interest.

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

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