New bond offers must fit into your portfolio

Check if you need to invest in the asset class to which the bond belongs, then see if the bond has the right risk-return profile

“Should I invest in the bond issue of XYZ Finance Limited, which is paying 10 per cent?” Or, “Should I invest in the corporate deposit of ABC Housing Finance Limited?” These are questions I am asked often in the current low interest-rate environment.

This is the wrong question to ask. It is a bit like asking if a particular brand of tyre is suitable as a replacement tyre for your car. One cannot answer this question without knowing the kind of journeys you undertake, the destinations you want to reach, the kind of roads you will encounter, the kind of driver you are, the car you own, and finally, the brand of the other three tyres that are required to work with the new one.  

People obsess over picking winners. But an entire body of research shows that more than 90 per cent of the eventual investment return comes from choosing the right asset classes — equity, debt, real estate, gold, alternative assets, etc with further division into domestic and international within them — and making the right allocation to them. Less than 10 per cent of the eventual investment return experience can be attributed to the choice of securities within an asset class. Hence, even if you were to invest in the index of each of the asset classes you invest in, you are likely to get the return you need 90 per cent of the time at much lower risk. 

Asking whether a particular security is a good investment is an incorrect question. To answer this question, one needs to know the person’s goals (his destinations), his risk appetite (the kind of driver he is), his existing investments (the other three tyres in his car), his priorities (his route map), and resources available for making investments.

Based on all this information, one should determine an ideal allocation between equity, debt, gold, international equity, real estate, etc. Once that is done, see whether the asset class to which the security (that you want to purchase) belongs has a gap (requires more investment). Then ask whether that security fits in on criteria such as risk, return and liquidity. In this case, the client needs to ask whether the corporate bond or deposit fits into her debt allocation.

For most retail investors, the need to invest in long-term debt securities can be satisfied by statutory savings like Employee Provident Fund and/or National Pension System, or the debt portion of balanced or balanced advantage mutual funds. Some of the debt allocation can also be satisfied by high yielding small savings products like Public Provident Fund and Sukanya Samriddhi Yojana.

The needs of retired people, who have a conservative risk profile and hence a large debt allocation, cannot be satisfied with the above-mentioned products alone. Even for them, however, it does not make sense to invest in a single issue of such bonds, as that would create concentration risk. It is far better for them to invest in an appropriate debt mutual fund that invests in such corporate bonds, among others. The yield may be a tad lower than what you would get from a direct investment, but it is more than made up by the spreading of risks across various instruments, and the ability to withdraw money when needed. The tax advantage offered by a mutual fund makes up for the expense ratio.

Next time you ask me if you should invest in a corporate bond or deposit, expect a long answer along these lines.

The writer heads Fee Only Investment Advisers LLP, a Sebi-registered investment adviser