Introduction:
First and foremost, an investor must devise an all-round investment strategy focussing on creating a well-balanced portfolio. A well-balanced portfolio must consist of diversified financial instruments including stocks, mutual funds, Exchange Traded Funds (ETFs), bonds, real-estate properties, physical/digital gold, Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InVITs), in addition to the liquid funds set aside for emergency purposes. The main idea is to mitigate losses, attain long-term growth and thereby achieve goals.
While diversifying your portfolio, care must be taken to earmark a portion in the portfolio for fixed-income-generating financial instruments, such as bonds, which provide you steady and stable returns. Though faster financial growth is possible only through equities, getting a fixed stream of income even during the times of market crashes is crucial and could not be ignored at all.
Now, we know the importance of a balanced portfolio. But it’s not just enough to add bonds to your portfolio. Creating a right combination and a wide variety of bonds in the portfolio is equally important.
Read on to know the rudimentary, yet inevitable, approach to frame a well-balanced bond portfolio that is in apt alignment with your long-term goals and risk appetite.
Let’s dive into the nitty-gritty.
Step 1: Zero-in on investment goals
Defining your investment goals is the initial step in the ladder of building a well-balanced bond portfolio. Further, you need to have clarity on the time horizon and capital requirements. You should know when you want the capital back, how often do you need the interest, monthly, quarterly, half-yearly or yearly. Do you want the money to grow in the long-term or just need a stable interest regularly. So, it is only your goals that would determine the types of bonds that would suit you.
Step 2: Know your risk appetite
You must have a clear idea of how much aversion you have for risk. Unlike stocks, bonds are comparatively less risky, but not all bonds carry the ‘low-risk’ tag. Often, risk and rewards are intertwined, the more the risk, the more the returns/rewards and vice-versa. Bonds that fetch higher interest have higher risk and lower-interest bonds, say for instance, government bonds, have lower risk. It’s only if you have clarity in gauging your risk tolerance, you can create a right combo of bonds in your portfolio.
Step 3: Diversification of bonds
Diversification is the key to mitigating risks. That is, you are spreading your bond investments across all segments. In the market parlance, experts often consider that the correlation between various asset classes is very little. If fact, they suggest that there exists an inverse correlation between the asset classes. This is how an inversion works – when both the equity benchmark indices (Nifty and Sensex) are bullish, other asset classes such as bonds, real estate and commodities might tumble. In contrast, when the equity segment nosedives, other asset classes might fetch you extraordinary returns. That’s why financial experts advise you to maintain a well-balanced portfolio. The same logic applies to maintaining a well-balanced portfolio as well.
One of the major risks in the bond segment is the default risk. This means that an issuer of the bond would fail to pay you the interest component on time or return your initial principal amount at the time of maturity of the bond. That’s why by diversifying the bonds in the portfolio, you can avoid the default risk of single bond issuer as the risk is spread across the varied bond types. Let’s say for instance, Bhupesh holds ₹10 lakh each in bonds A, B, C, D and E; and Kamesh holds ₹50 lakh in bond B. If the issuer of the bond B defaulted, Kamesh would have lost the entire ₹50 lakh whereas Bhupesh would have lost just ₹10 lakh as his other bonds are intact. Do not put all eggs in one basket.
Strategies for bond diversification:
1. Bond-type diversification: See that your portfolio has a combination of government bonds, Treasury bonds, corporate bonds, bank bonds etc. Under the government bonds category, you can diversify further into Central Government bonds and State Government bonds. Bank bonds could further be diversified into bonds issued by various banks and not just one bank. This way, you have exposure to both low-risk bonds through the government bonds and at the same time get high returns through corporate bonds.
2. Based on maturity period: Generally, not all bonds have the same maturity period. They range from short-term (less than 3 years) to medium-term to long-term (more than 10 years). Therefore, a well-balanced bond portfolio must include bonds whose maturity period is spread out through the years. There are also perpetual bonds, which do not have a specific maturity period. The perpetual bonds are popular for their regular and steady income stream but are not completely risk-free.
3. Diversify by Issuer: We reiterate – do not put all eggs in one basket. Do not buy more bonds from the same issuer. Diversify and invest in bonds issued by different companies, different sectors, government, different banks etc. This way, you can mitigate the single-issuer defaulting risk.
4. Interest-type diversification: Investors can also diversify their bonds based on the type of interest they receive for their bond investments. For example, investors can include in their portfolio zero-coupon bonds (you can buy the bond at a deep-discounted price but they do not pay regular interest), fixed-rate bonds, floating-rate bonds, inflation-linked bonds etc.
5. Nature of conversion: You can also include convertible bonds in your portfolio, for which you have to read the offer document carefully. These are hybrid financial instrument that acts like a regular bond but at the same time provides an option to the investor to convert them into a predetermined quantity of shares of the bond-issuing company.
Step 4: Rebalancing your portfolio
Now that you have built a decent bond portfolio, but that’s not enough. Though your bond portfolio is well-balanced, you need to monitor the bond performance through the credit ratings, keep track of the interest amount credited, find out if there is any default of interest payment or not. Further, you can rebalance the bond portfolio regularly, by increasing or decreasing particular type of the bond based on the returns you have received. Also, constantly monitor news about bond issuers (of the bonds you have in your portfolio) so as to take prompt action at an appropriate time, if at all any untoward incident occurs.
Further in your overall portfolio, say for instance, you have purchased more stocks owing to market crash or the ‘buy-at-the-dip’ rule, your initial bond allocation of 50% in your portfolio might have been reduced as there are more stocks in your kitty now. So, you need to balance it either by buying more bonds or selling stocks, of course at a profit. Therefore, regular monitoring and rebalancing your bond portfolio is crucial, do this at least once in six months or yearly once.
Step 5: Credit ratings is your torch
Credit ratings play a vital role in the bond market. Generally, bonds with higher credit ratings (AAA, AA) are considered safe with low-risk when compared to bonds with lower credit ratings (BBB, BB, or lower) which carry higher risk. Bond risks and ratings are inversely proportional to each other. Higher the credit rating, lower the risk and lower the credit rating, higher the risk.
Step 6: Monitor micro/macro-economic indicators
Investors must be updated with the latest developments in the country at large. They need to follow news, and must keep themselves abreast of economic indicators such as Gross Domestic Product, inflation rate, unemployment rates, consumer price index, wholesale price index, Union Budget, overall sectoral performance etc. These indicators offer insights into the overall picture of the global- and Indian economy, which would directly or indirectly impact the bond prices and the interest rates.
Disclaimer: Investments in debt securities (bonds) are subject to risks including delay and/or default in either interest component or principal amount or both. Read all the offer-related documents carefully.