We believe optimal diversification in a goal-based portfolio involves having capital-appreciation products (equity funds) and income-earning (recurring deposit) products. Previously, we discussed costs/benefits of investing in recurring deposits (RDs). Preference to earn interest income has often been called to question. There are three reasons why we believe earning interest income is more optimal than earning capital appreciation on bond investments.

Stability vs. downside risk

RDs earn interest income. Bond funds provide capital appreciation, which can be greater than interest income. That said, following are the reasons why you should consider earning interest income rather than capital appreciation: One, bond prices are inversely related to interest rates.

That is, if interest rate declines, bond price go up. Therefore, funds that invest in bonds will generate capital appreciation when interest rate declines or when the bond market anticipates interest rate will decline. But by how much can interest rate decline?

That depends on inflation in India, which currently is upwards of 4%. A floor (bottom) on interest rates places a cap (ceiling) on bond prices and, hence, on capital appreciation. But there is no ceiling on interest rates which can rise for several reasons. That means bond prices can dip more than they can go up. Why expose a goal-based portfolio to such risk?

Two, equity investments provide capital appreciation but exposes your portfolio to downside risk. It means you need income returns to provide stability to portfolio. Hence, RDs. In times of market crisis, when equity funds generate negative returns, RDs can provide stable returns.

Finally, interest-earning products such as RDs provide visibility of cash flows. Ignoring the small risk that the bank will default, you know today the maturity value of deposit. In contrast, your investments in bond funds fluctuate based on net asset value, which depends on the market price of the bonds in the portfolio.

Conclusion

Our argument does not consider taxes, as norms change. Note, capital appreciation via investing in an active bond fund is taxed at marginal tax rate of 30 per cent similar to interest income. Choosing between bank deposits and bond funds is a choice between stable returns and higher expected returns with downside risk. A portfolio with a judicious mix of capital appreciation and income returns is optimal.

(The author offers training programmes to individuals to manage their personal investments)

Published on December 16, 2024