As an asset class, bond plays an important role in your personal finance. In this article, we discuss how to choose bond investment for a goal-based portfolio. We also discuss why risk associated with bonds are different from that of bond funds.
Your investment portfolio will typically carry two asset classes viz. equity and bonds. Your exposure to equity will be typically through mutual funds. You have a choice for your bond exposure.
Both institutional investors and individual investors aim for capital appreciation on their equity investments. Dividend income is add-on cash flow, given that dividend yields are low and dividend income is no longer tax efficient.
The source of returns on bond investments can differ between institutional and individual investors. You can set up your bond investments to earn only interest income whereas institutional investors can choose their investments to earn capital appreciation. The question is: Why earn only interest income?
Note that by bonds as an asset class, we mean all interest-bearing instruments ranging from fixed deposits to government bonds. If you invest today for an 8-year period, you want to know with certainty the cash flow you will receive after 8 years. Bonds can provide such certainty, but only if you aim for interest income. For instance, you will know the maturity value at the time you make an 8-year recurring bank deposit. Ignoring the small credit risk, this certainty helps you in accumulating the desired wealth to achieve your life goal.
Many choose to invest in bond funds because the returns are greater than the interest income on bonds. The downside is that you are exposed to market risk. This leads to uncertainty in cash flows that bank deposits do not suffer from.
Note that bond prices decline when interest rate increases, or when the market anticipates an increase in interest rate. You are exposed to this risk through the net asset value (NAV) of a bond fund.
Then, there is another factor to consider. How will you select your bond funds? Bonds have a finite life. So, if you hold them till maturity, you will receive fixed interest income through the life of the bond and par value on redemption. But bond funds actively trade on bonds and are, therefore, exposed to market risk. The risk of a bond fund is measured by its modified duration. Suffice it to know that if a modified duration of a bond fund is 5.6, then the portfolio value will decline by 5.6% for an 100 basis-point increase in yield in all the bonds in the portfolio.
So, this leads to two questions. One, do you want uncertainty from your bond investments too? And two, if so, how will you relate a bond fund’s modified duration to your life goal?
A simple rule can be to invest in equity for capital appreciation and in bonds for income returns. Your equity investments have the capacity to deliver high returns but also carry high downside risk. Your bond investments (read bank deposits) could provide stable cash flows but lower returns. Note that bonds do not carry potential for high returns. This is because capital appreciation in bonds is driven by decline in interest rates. And interest rates do not typically decline sharply.
The above argument is not to suggest that you should not consider bond funds. Rather, it is to enable you to make informed decision. Choosing a bank deposit is easy — you can match the maturity of the deposit with the time horizon of your life goal.
Matching a bond fund’s modified duration with the time horizon for your life goal is not optimal. A fixed maturity plan (FMP), a closed-end fund, could work but only if you find a fund whose life matches with the time horizon for your life goal.
(The author offers training programme for individuals to manage their personal investments)