Portfolio Ideas. Why bond is optimal for high-priority goals

In this column we discuss the floor-upside rule. It applies for portfolios designed to achieve high-priority goals. Briefly, your bond allocation acts as the floor and your equity allocation creates the upside.

We received queries from readers who were uncomfortable with the large capital required to implement this rule. Specifically, the readers wanted to reduce capital by creating a floor with bonds and equity. In this article, we show why a bond-only floor is better than a floor created with both bonds and equity.

Capital requirement

Suppose you want to accumulate ₹90 lakh in 10 years to make 20 per cent down payment for a house estimated to cost ₹4.5 crore.

At the minimum, also suppose you require ₹3.375 crore to buy a smaller house. The floor-upside rule requires you to invest only in bonds to accumulate the down payment to buy the smaller house (₹67.5 lakh).

That means you have to invest ₹43,500 every month in RDs for 10 years earning 4.9 per cent post-tax compound interest.

But you are still short of ₹22.5 lakh, which is 20 per cent of ₹1.125 crore, the difference between the cost of your preferred house and that of the smaller house.

So, you have to invest ₹10,400 every month in an equity fund for an expected post-tax return of 10.8 per cent to create the upside. In short, you have to invest ₹53,900 every month to accumulate ₹90 lakh in 10 years.

If you apply the standard rule of allocating 60 per cent to equity and 40 per cent to bonds, you have to invest ₹48,150 every month, 12 per cent less than the floor-upside rule-based portfolio.

The floor-upside rule requires more capital because the expected return on bonds is lower than that on equity. And you need a higher bond allocation to create the floor. But the floor-upside rule helps you achieve your basic goal (smaller house) even if equity prices tank.

The question is: is a floor using both equity and bonds more optimal?

Typically, equity declines by not more than 50 per cent during a financial crisis. For instance, the holding-period return on the NSE 50 index between January and December 2008 was -43 per cent even though the index had lost 52 per cent by October 2008.

So, you can create an equity floor, hoping to recover at least 50 per cent of your investment value during market crashes.

Suffice it to know that you need more capital if you use both equity funds and bank deposits to create a floor than if you use only bank deposits.

Why? Your portfolio has to accumulate double the required amount in an equity floor to cushion a possible 50 per cent price decline in the last year of the time horizon for your life goal.

Continually protecting the value of your equity floor can be challenging.

Creating your portfolio’s floor with only bank deposits is easy and provides stable cash flow, which is critical for your high-priority goals.

The writer is founder ofNavera Consulting.Send your feedback to portfolioideas@thehindu.co.in

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