Previously in this column, we discussed why an optimal goal-based portfolio should contain equity funds (preferably passive funds) and bank fixed deposits.
The recent change in tax laws on bond funds strengthens this argument; returns on such funds will henceforth be added to your income and taxed at your marginal tax rate instead of being taxed as long-term capital gains if held for more than 36 months. In this article, we revisit the argument of why bank deposits are preferable for goal-based portfolios.
Investment products with income returns are suitable for goal-based portfolios as they reduce the uncertainty associated with market-oriented investments. But you may have to take on other risks to achieve such stable returns.
For instance, investment in government bonds provides stable cash flows but exposes you to reinvestment risk — the risk that you may be unable to reinvest interest incomes on the bond at a required rate to achieve your life goal. The point is that you should choose investments whose associated risks you are willing to bear.
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It is in this context that you should compare bank deposits with bond funds. You know the maturity value when you invest in cumulative bank deposits and recurring deposits. The trade-off is that you should be willing to take some credit risk and accept lower returns for knowing the cash flows you will receive at maturity.
In contrast, bond funds can generate higher returns because capital appreciation is the primary source of returns. Bond prices go up when interest rates come down. And a bond fund’s net asset value (NAV) goes up when bond prices move up. But there is a limit to how much return bond funds can generate because interest rates typically do not decline significantly.
On the other hand, interest rates can go up when inflation expectation is high. That is when bond prices go down, dragging down the bond fund’s NAV.
The primary objective of a goal-based portfolio is to aim for stable returns, which bank deposits can provide with some amount of credit risk. But such deposits offer lower post-tax returns, requiring you to seek other investments that offer higher upside potential (read equity funds).
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True, bond funds offer some upside potential, but with uncertain returns as NAVs are marked to market. You should prefer income returns from one asset class and upside potential from another in your goal-based portfolios. Hence, the argument for bank fixed deposits and equity funds.
(The author offers training programmes for individuals to manage their personal investments)