Bonds - How they fit into your investment portfolio
How much of equity you need to own and how much of bonds? That is the fundamental question that most investors have in their mind. One of the most commonly used (although not scientifically proven) methods is the popular (100 – Age) formula. What this formula basically says is that if you are 30 years old then you must have a 70% exposure to equities and if you are 60 then you must have a 40% exposure to equity. While there is no real scientific basis to this formula, what it captures is that as your risk appetite reduces with advancing age. This is intuitively correct!
You basically need to understand the role of investment bond in your portfolio and why you need to be invested in bonds. Let us look at what is a bond and what is a bond fund and why you should invest in them?. Let us understand what role bonds (debt) play in your overall portfolio mix and what are the benefits of investing in debt mutual funds
Bonds give stability and predictability to your portfolio mix
Equities are a must in your portfolio for the sake of growth and wealth creation but that alone is not enough. It also requires an element of stability and predicta`bility that only comes from debt. When you invest in bonds or in bond funds, the returns may be lower than equities but these returns are more stable and you can count on these returns. With debt in your portfolio your immediate milestones are safe and less volatile.
If you want regular income, then debt is the way to go
Not everyone thinks of creating wealth over the next 25 years. There are millions of Indians who rely on their investments for regular income. This can either be in the form of interest on bank deposits or dividends on bond funds. Equities also pay dividends but there is no assurance or guarantee of the same and your company is not obliged to pay dividends. Instead, you can structure a debt fund as a growth plan or as a dividend plan but either ways you can be assured of regular income. There are different tax implications based on how you take money out of the fund but what matters is that if you need regular income from your corpus. Irrespective of the structure, debt exposure gives you regular flows.
Debt is useful in tempering the risk of the portfolio mix
Normally, with advancing age and shrinking income levels your risk appetite reduces. The challenge is to use bonds or debt funds to consistently keep reducing and tweaking the average risk of your portfolio. In the pecking order of assets, equities have the highest risk and debt funds carry much lower risk as they invest in assured return debt products and are less volatile. This makes debt funds ideal candidates to reduce overall risk of the portfolio.
Bonds and bond funds give liquidity around goal milestones
Let us assume that you have a target of reaching a corpus in 20 years to pay for your daughter’s foreign education. It is hard to make money on debt over a longer period of time and hence you must look at a bigger allocation to equities. But what happens as you approach the milestone? Ideally, you should keep prudently increasing the exposure to debt funds or liquid funds so that around the milestone your risk of loss on liquidation is almost minimal. Debt funds play a key role in balancing risk and returns closer to milestones.
Debt products can e dynamic and also flexible
Debt, as an investment option, is extremely dynamic and flexible. Debt has a lot of sub components too. Consider two instances! If you find that the risk of shifting from AAA rated debt to AA rated is not too high, then you can do quality-fishing by shifting to bonds with lower rating profile. Secondly, when interest rates are likely to fall, you can tweak your debt fund portfolio to include more funds with longer maturity so that you can get the best benefit of price appreciation.
If you opt for debt funds, they can be tax efficient too
Debt funds are fairly tax efficient when compared to other debt products. For example, interest earned on bank FDs and corporate FDs are fully taxable at the peak rate applicable to you. If your returns on debt funds are structured as dividends then you do not have to pay any tax on your dividend income although the fund does deduct the DDT at 29.12%. However, if you structure your debt fund as a growth plan and hold it for more than 3 years then it is classified as long term capital gains. In this case the entire return earned over 3 years is taxed at just 20% with indexation benefits. The effective rate of tax comes to below 10% when indexation is considered and that makes debt funds substantially more tax efficient than FDs. You can also structure withdrawals in the form of SWPs.
There is certainly value in adding debt to your portfolio. It not only makes your portfolio more stable and predictable, but also makes your debt exposure more tax efficient. That is the reason why gentlemen prefer bonds!