If you have been investing for a while now, you are most likely to have a significant proportion of bonds in your portfolio. Unlike equity, bonds have finite maturity. So, if you buy and hold a bond till its maturity, your only source of return will be the interest.

But it is important to manage your interest income if you want to meet your goals. Here is why.

The need to reinvest

You invest to accumulate wealth to meet a life goal, such as your child’s college education. Suppose you need ₹1 crore in 10 years and you are willing to set aside ₹45,700 every month to achieve this goal.

Your portfolio should earn a required return (called minimum acceptable return or MAR) of 11 per cent every year to accumulate the targeted wealth.

At the end of the first year, your portfolio should have ₹5.82 lakh consisting of ₹5.48 lakh of capital contribution and ₹34,000 of returns, comprising realised gains, unrealised gains and dividend income from equity investments and interest income from bond investments.

But your portfolio will be on track to achieve your goal only if your capital contribution for the second year (₹45,700 x 12) along with ₹5.82 lakh carried over from the first year earns 11 per cent return. In other words, 11 per cent MAR refers to compounded annual return.

You should, therefore, reinvest the annual interest that is paid out on your bonds. However, this is easier said than done.You will be subject to reinvestment risk — you may have to reinvest your interest income at a lower rate due to decline in interest rate. If this happens, you could face a shortfall in your target wealth at the end of the investment horizon.

Then, there is the issue of keeping track of interest income and the reinvestment. All your bonds are unlikely to pay interest at the same time. If you receive interest income through the year, you will have to make several reinvestment decisions.

And that may not be easy, due to the time and effort involved. So, what should you do?

Reinvestment process

You can moderate the reinvestment risk by investing in bonds that pay interest at maturity. That is, you should go for the cumulative option in fixed deposits or debentures. This way, you will be able to shift the reinvestment risk to the bank, at least for a few years.

But what if you invest in bonds that compulsorily pay annual interest? For easy operation, maintain a separate bank account for your investments. So, all your interest income will be automatically credited to this account. Next, wait till you reach a pre-determined threshold interest income, say, ₹50,000, before you make a reinvestment deposit.

Or, you can have a pre-determined time threshold — you can accumulate your interest income and reinvest every three months. Remember, you cannot keep interest income in your savings account for too long, as the proceeds have to earn MAR to meet your life goal.

You can also combine your interest income with realised gains from equity investments to create the reinvestment deposit. That way, you will have a sizable amount to reinvest and also make fewer reinvestments in a year.

You could spend returns in excess of MAR in any year. But it’s better to reinvest such excess returns in bonds and use the proceeds to bridge any shortfall in years when your portfolio earns less than MAR.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in