For fixed income, return expectation is not the only parameter
With lower inflation, returns from short-term bond funds would be enough to beat inflation and generate real positive returns
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When it comes to shifting from one investment category to another, particularly from a high-return category (say, equity) to a category of lower-return expectations (say, fixed income), there is a natural aversion to the latter and most would prefer to stay with higher returns. However, that is not the right approach to deploying your money. We will discuss why.
At the current juncture, in the fixed income space, your adviser must be telling you to stay with short-term bond funds, that is, not to venture into long-bond funds as the interest rate cut cycle seems to be bottoming out. The return expectation from short-term bond funds is relatively muted now, particularly with interest rate cuts being largely over. The difference in returns expectation looks all the more stark when you see equity returns at, say, 15%, and in single digits for short-term bond funds.
The essence of diversifying your portfolio is that the two or more investment categories should ideally have a negative correlation, that is: when one asset goes up, the other should not go up as much. It may seem inimical to you because ideally you would want all your investments to move up uniformly.
However, these are market-driven investments and the purpose of diversification is to avoid a situation in which your entire portfolio, or both the components of your portfolio, are not doing well. If you invest in only one asset class, there would be certain phases when this asset would not perform so well, and your entire investment would be dependent on a particular set of market forces. If you diversify, a part of your investments into a different asset class would benefit from these very set of market forces, and you are better off to that extent. In the long run, you are optimising your returns. When you are allocating a part of your portfolio to, say, short-term bond funds against 100% allocation to equity, you are reducing volatility in your portfolio to that extent. That is to say, you have to look at the overall perspective. Hence, when you are shifting a part of your money from equity to fixed income, you are not reducing your returns as such but moving that component from one ‘box’ to another ‘box’ that suits your profile, risk appetite and the horizon of investments.
Allocation is easier for fresh deployment as there are lesser mental blocks. You have to see which ‘boxes’ suit you and you must put your money into those ‘boxes’ proportionately. Ask your adviser why that investment avenue is suitable for you, and not just ‘what is the returns expectation’. For example, equity is to build wealth over a long horizon, but may be volatile in the interim period. To fulfil that objective, large-cap equity funds may be more suitable. If your objective is to achieve gains over the medium term, your preference would be promising mid-cap funds. In the fixed income space, the logic behind recommending short-term bond funds over long-term bond funds is that scope for gains from interest rates coming down is unlikely, rather, if interest rates move up, long-term bond funds would underperform. The objective here is goal-based investment with relatively lower risk-return profile.
Having discussed the logic of suitability over expected returns, let us now see if it is possible to enhance returns to a certain extent. It is possible to achieve relatively better returns than short-term bond funds through:
a) credit-play corporate bond funds that have a higher portfolio running yield, provided you are comfortable with the credit exposures in the portfolio;
b) tax-free bonds where the ‘pre-tax equivalent’ yield is still attractive, depending on your tax bracket;
c) preference shares with decent yield, defined dividend rate and tax efficiency but relatively low secondary market liquidity; and
d) structured debentures (only if you understand them fully), where interest rate is contingent upon a movement in the equity market but they behaves like coupon-bearing bonds due to a pre-defined range of interest. But you will need the minimum investment size required.
Another factor working in favour of fixed income instruments, and which counters the bias of lower-return expectations, is the relatively lower inflation. We are in a phase of structurally lower inflation from the double-digit numbers at one point. The measure of inflation is now based on a basket of consumer prices (CP), and this is better than the wholesale basket followed earlier. CP inflation was 3.8% in March 2017. Even if it moves up, it is expected to be in the range of 4.5-5% over the next 1 year or so. Thus, even if short-term bond funds yield relatively lower returns than the last couple of years, which was helped by the rate-cut cycle, it would be enough to beat inflation and generate real positive returns.
For the ‘alpha’ (higher returns) in your portfolio, stay put in equities with a long horizon.
Joydeep Sen is managing partner, Sen and Apte Consulting Services LLP.