At times, asset classes such as equity and gold can turn volatile in the short term. Hence, an investor needs to build a diversified portfolio with asset allocation. During such volatile times, the fixed-income component of the investment portfolio can act as a shock absorber, providing the much-needed stability. Within the fixed-income category, depending on their needs, an investor can choose from various financial products, including bonds. Having bonds in an investment portfolio has several benefits. In this article, we will look at some of the reasons why bonds should be a part of an individual’s investment portfolio.
Why should bonds be a part of the investment portfolio?
1. Asset allocation: Different asset classes take turns to outperform each other year after year. Hence, it is essential to build an investment portfolio spread across various asset classes, such as domestic and international equity mutual funds, fixed income, gold and silver, real estate, etc. Every asset class plays distinct role in the investment portfolio. For example, equity is for growth, fixed income is for stability and regular income, and gold is a hedge against inflation and a safe haven during times of uncertainty.
While equity is for growth, in some years, it underperforms and gives negative returns. During such years, bonds and other fixed-income products in the investment portfolio provide stability to the overall portfolio. The fixed-income component helps navigate the uncertain times till the growth resumes. With appropriate asset allocation, an investor can earn risk-adjusted optimum returns.
2. Predictable returns: Bonds have a fixed coupon rate, specified at the time of issuance. A bond pays the periodic interest rate throughout the entire tenure. So, bonds provide predictable income. For example, an individual invests in a bond with a face value of Rs. 1,000. The coupon rate is 8.00% per annum, and the tenure is 5 years. In this case, the bond will provide the individual an interest amount of Rs. 80 per annum for 5 years.
3. Regular cash flows: The frequency of interest payments on a bond varies. It can be monthly, quarterly, half-yearly, yearly, or on maturity. The interest payment frequency is specified at the time of bond issuance. Some bond issuers offer different variants of the same bond with different interest payment frequencies. It provides an investor with an option to choose a bond variant with an interest payment frequency that suits their requirement.
For example, suppose an individual is looking for monthly interest income from a bond to complement their monthly salary income. In such a scenario, the individual can choose a bond with monthly interest payments. Thus, the individual can enjoy monthly cash flows from the bond. On maturity, the principal is repaid to the investor.
4. Low credit risk: An individual can choose from various bonds to invest in. An investor with a conservative risk profile can consider bonds with a low credit risk. For example, Central Government bonds (G-secs) are backed by a sovereign guarantee. Hence, the credit risk in these bonds is the lowest. Bonds issued by the State Governments (SDLs), municipal corporations, public sector undertakings (PSUs), and public sector banks (PSBs) carry low credit risk.
Among other entities, an individual can consider bonds issued by corporates with higher credit ratings. In India, bonds with credit ratings ranging from AAA to BBB- are considered investment-grade bonds. Bonds with an AAA credit rating have the lowest credit risk. As the credit rating moves lower, the credit risk increases.
An individual can consider secured bonds with collateral. The collateral is on the bond-issuing company’s specific assets. In the event of a default, these assets can be sold in the market, and the sale proceeds can be used to pay bondholders.
Thus, an individual can consider bonds with lower credit risk, such as Government bonds, corporate bonds with a higher credit rating, or secured bonds.
5. Potential for higher returns than other fixed-income products: Some bonds have the potential to provide higher returns than some other fixed-income products. For example, most big banks currently offer interest rates of 6% to 7% per annum on fixed deposits with a tenure of 1 to 5 years. Most bonds are offering higher coupon rates for similar tenures. Within bonds also, the coupon rate varies, depending on the type of bond chosen. For example, corporate bonds usually offer a higher coupon rate than Government bonds.
Similarly, the coupon rate varies across secured and unsecured bonds, investment-grade and non-investment-grade bonds, and other categories. However, a higher interest rate usually comes with a higher risk. So, an individual should consider their risk profile and other factors, along with the coupon rate, while choosing a bond.
Build a stable investment portfolio with bonds
There are several benefits of including bonds in an investment portfolio. They stabilise the overall investment portfolio when equity and gold are volatile. Bonds can provide predictable returns and regular income to suit an investor’s cash flow needs. More importantly, bonds can provide all these benefits with a lower credit risk. Thus, bonds can be an essential part of an individual’s investment portfolio.
