In 2020, investors witnessed unprecedented volatility in the conventional financial markets. Stocks of several famous companies dipped as much as 50% in just a matter of months.
Such uncertain and unpredictable market spells teach investors a crucial investing lesson, the need for a diversified balanced portfolio.
Fixed-income instruments like bonds make up a crucial element of a strategically balanced portfolio.
In this post, I’ll talk about how you can create a balanced portfolio with bonds. We will look into the basics of bond investing, strategies to create a bond portfolio, how you can add bonds to your mutual fund portfolio, and the basics of portfolio diversification.
What are Bonds, and How do they Work?
Let’s start with a brief explanation of what bonds are, and how they work.
Bonds are basically a way of raising capital by entities, which can be private corporations or government-owned ventures. For private corporations, we’ve corporate bonds, and for government entities, we have government bonds or securities (popularly called “government securities” or “G-Secs”).
Debt and equity are the two fundamental ways of raising capital. Debt simply means a loan, given in exchange for interest payment, and equity simply means ownership.
A bond is a debt instrument. Businesses and governments issue bonds to raise capital. In exchange, they give the promise to pay the principal amount, plus, an interest rate, just like how bank loans work.
The primary difference, however, between bonds and loans lies in the fact that bonds can be traded, and the bondholder can sell them before maturity. While in the case of loans, it is an exclusive agreement between the creditor and debtor. The loan can be assigned or sold through off-market transactions in a bilateral deal.
Now since a bond is a debt instrument it is safer than equity or stocks of the same company due to lower volatility compared to equity as its value does not change significantly with market movement. Further, in case of bankruptcy, bondholders have priority over shareholders in claims on the company’s assets.
The Indian bond market is still in its early phase compared to several Western nations. After the liberalization, the bond market witnessed billions of dollars of investments flowing from foreign investors. Domestically, the bond market has largely been limited to financial institutions and high-net-worth individuals due to several reasons.
The size of the bond market is estimated to be $128 trillion worldwide and $49 trillion for the US market. In India, it is estimated to be at $2.1 trillion, while India’s equity market cap stands at $3 trillion. This is contrary to how things are in the West and the world as a whole. In countries like US and UK, the debt market surpasses the equity market by a large margin. In fact, the global debt market (including loans) in aggregate is about three times the size of the global equity market And the bond market is a large part of the debt market.
| Country | Total Bond Market (Trillion USD) | Total Equity Market Size(Trillion USD) |
| U.S.A | 49 | 46 |
| U.K | 7 | 3 |
| China | 21 | 12 |
| India | 2 | 3.4 |
Retail participation in the bond market is yet to become popular in India. However, things are changing fast, with fintech platforms democratizing bond investing and opening it up for average investors at low ticket sizes. Now with this basic understanding of bonds, let’s see why portfolio diversification is so important when it comes to investing.
Portfolio Diversification using Bonds: What, and Why?
No single asset class can give you consistently high returns all the time. Also, if someone creates a very concentrated portfolio of very few asset classes or securities then any unfavorable impact on that asset class can have a huge impact on the overall portfolio.
In the last two years, markets have been battered by several external factors. First, the pandemic and the subsequent lockdowns, and then incessant money printing by the central banks and now soaring inflation and climbing interest rates.
Most millennial investors have witnessed something like this for the first time. Stocks of several infallible companies dipped by almost 40-50% for a short period of time. Cryptocurrencies, touted as the new age asset class wiped off billions of dollars of investors’ wealth. But there’s a silver lining to all this. It has taught the next generation of investors a very important lesson, the need for creating a strategically balanced diversified portfolio.
Portfolio diversification is the process of investing your money in different asset classes like stocks, bonds, mutual funds, gold, etc. This is done to minimize the risk of investing. Usually, when one asset class performs badly, other asset classes soothe the impact by acting as a hedge.
Diversification is essential at each step of investing. Be it diversification in different asset classes, or diversification within a particular asset class.
A balanced portfolio is basically a strategically diversified portfolio with different asset classes allocated as per your investment goals, financial needs, and abilities. Although there’s no fixed thumb rule, and it varies from person to person, the basic tenet of creating a balanced portfolio is to allocate your funds to high-growth assets like stocks, and low-risk instruments like bonds to mitigate the downturns. Having a mix of bonds and equity also helps in making your portfolio less susceptible to market volatility. Having investments in bonds can also help you manage your financial goals and budget in a better way as cash inflow is predetermined and investors can match it with their future requirements.
How to Create a Balanced Bond Portfolio?
Bonds are a vital component of a strategically balanced portfolio. They act as a cushion against the volatile nature of stock markets. To understand how you can create a balanced bond portfolio, you first need to know the types of bonds available and their key features.
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Government Bonds or Government Securities (G-Secs)
Government bonds continue to remain an investor favorite. In India, Government bonds are issued by the Central Government or State Governments to raise capital for various projects and schemes. These bonds are entrusted with the utmost safety and credibility.
- PSU Bonds
These are bonds issued by Public Sector Undertakings (PSUs). Government shareholding in PSUs is generally more than 51%. PSUs carry an implicit Sovereign guarantee; hence the credit risk in these PSU bonds is low. This does not mean that these are completely risk-free. In September 2019, the rating of Bengaluru Metropolitan Transport Corp. (BMTC), a state government PSU, was downgraded by ICRA to D (default) on account of delays and irregularities of payment Furthermore, for some PSU bonds the interest income is 100% tax exempted(eg NHAI.
- Corporate Bonds:
These bonds are issued by private companies to raise capital, usually for expansion plans. Obviously, corporate bonds are comparatively less secure than government or PSU bonds, but they do come with a relatively higher coupon rate and yield. Pertinently, bondholders have the first claim on the company’s assets in case of bankruptcy.
Just like how things are in a stock market, where you have blue chip companies, potential multi-baggers, and high-risk penny stocks, in the bond market as well, you have different types of bonds.
How to invest in Bonds?
Based on the kind of bonds available on various platforms I have created a table. Most platforms have more focus on one category and hence offer more variety in that. Apart from these platforms, some listed bonds can be traded but for most volume is too low.
The below platforms have bonds ranging from low-yield AAA corporate bonds offering 8% to High Yield Venture Debt and Real Estate Backed Debt also.
| Bonds | Returns | Platform | ||
| Government Bonds, PSU, AAA corporate | 7-10% | The Fixed Income | ||
| High Rated Corporate Bonds | 9-11% | Grip Invest | Wint Wealth | |
| High-Yield Corporate Bonds | 10-14% | Altifi | Jiraaf | Grip Invest |
| Real Estate, Unlisted Debt, Venture Debt | 13-18% | Jiraaf | Leafround | Yieldwisex(real estate only) |
Most High yielding bonds generally have low ratings or are unrated. Investors should do a deep dive into the balance sheet, cashflows, and other publicly available information to evaluate these bonds
To check out the detailed review and performance of each platform you may check out the below link :
Risks in Bonds?
Government securities are associated with the utmost security, but their returns are quite low. Most government bonds have a maturity period of around 10 years. These bonds offer lower interest rates than inflation rates, meaning, you technically lose money over the years.
Long-duration government securities also come with what investors call the “duration risk”. Duration risk is the risk of change in the bond’s price in response to changes in the interest rates. Duration doesn’t indicate the period till maturity of a bond, it rather indicates the price sensitivity of the bond, with respect to changes in the interest rates. The higher the duration, the more a bond’s price will drop as the interest rate rises. For example, a 1% hike in interest rate would mean a bond with a five-year duration would lose almost 5% of its value. This is one of the most significant, yet unknown risks associated with investing in long-term government securities.
PSU bonds give a slightly higher return than G-secs, but again due to the low-risk factor, the returns may not seem very lucrative to a young investor.
Corporate bonds have a risk-return characteristic that is in-between equity and PSU bonds. Corporate bonds usually come with a greater yield-to-maturity and coupon rate. You can create a portfolio allocation of bonds and equity based on your Age, Financial goals, and Risk Appetite.
And while you invest in bonds, make sure you consider the basic parameters before choosing one. These include the coupon rate, Credit rating, Face value, Premium or discount, accrued interest, type of debt (secure, senior, etc.), and most importantly, yield-to-maturity or simply, yield.
However, short-term debt funds are mainly unable to beat the impact of inflation as they invest only in selective securities.
Corporate bonds are debt instruments issued by private as well as public corporations to raise funds for the expansion of business. The issuer company borrows money from the investors and promises to return it with the predetermined interest rate on a specified maturity date. A bond rating is determined by a rating service that indicates its credit quality. The rating takes into consideration a bond issuer’s financial strength or its ability to pay principal and interest in a timely fashion. Unlike company’s equity stock investors, bondholders don’t enjoy an ownership status but are only considered lenders and receive interest periodically. However, in the event that the issuer defaults on its bonds and goes bankrupt, bondholders have the authority to claim over the company’s assets and cash flows if they are secured. Here, the seniority of the bond will determine the bondholder’s priority of the claim. For instance, priority will be given to the person who had invested in a secured bond, over an investor who had invested in an unsecured bond. In the case of a secured bond, the company pledges specific collateral—such as property, equipment, or other assets that the company owns—as security for the bond. If the company defaults, holders of secured bonds will have a legal right to foreclose on the collateral to
satisfy their claims.
The corporate bond market size in India has grown at 14% CAGR from INR 10.5 Lakh Crore to approx INR 40 Lakh Crores in the past 10 years. In the coming years, the Indian bond market is likely to witness a massive jump, backed by retail participation, which at the moment remains minuscule. A study by CRISIL suggests that India’s bond market size can double by 2025.
Conclusion
Corporate bonds can help to diversify the portfolio and enhance returns. After the benefit of debt mutual funds has been taken away corporate bonds are an interesting avenue to explore. I keep a large allocation of my portfolio to corporate bonds. I post a monthly review of the various bonds I have participated in and the overall performance of other assets in my portfolio.
