Liability-driven investment: Are bond funds the optimal choice?

Bonds are essential part of an individual investor's portfolio. This article explains Bond portfolio management and discusses how these factors affect an individual's choice of bond investments.

Investing should be for a purpose — to achieve a desired expenditure that investors want to fulfil. In portfolio management, such a process is called liability-driven investment (LDI). Equity and bond investments are essential part of any LDI portfolio.

The question is: How should investors take their bond exposure? This article explains bond portfolio management. It then shows how the factors driving active bond strategies impact individuals' choice of bond investments, especially bond funds.

Bond provides two sources of returns — income return and capital appreciation. Consider an 8 per cent 10-year bond. Income return is the interest received on the bond, amounting to 8 per cent per annum. Any change or perception of change in interest rates leads to change in bond price, translating into capital appreciation or depreciation.

Now, equity portfolio managers generate excess returns over the benchmark through security selection. In the case of bonds, at the extreme, securities with same maturity and same default risk should sell at the same price, making bond selection less important.

Bond portfolio managers deliver excess returns through duration management and credit management. Duration is the sensitivity of the bond portfolio to changes in interest rate.

If a bond portfolio manager expects interest rate to decline, she will buy bonds with higher duration than the bonds in the benchmark index. This will result in the portfolio generating higher returns than the benchmark index.

Credit management refers to the selection of credit sectors that perform better than the bonds in the benchmark index. A bond portfolio manager may buy A-rated bonds in anticipation of the economy picking up. And if the economy does clock higher growth rate, A-rated bonds could be upgraded, leading to capital appreciation.

The question is: Can investors optimally take advantage of such strategies through bond funds?

This can be best answered by discussing the issues related to bond portfolio management. One, equity funds use benchmarks created by the stock exchanges. Bond funds, on the other hand, adopt indices provided by firms such as CRISIL and ICICI Securities. The constituents of these benchmarks are not readily available to the investors. Analysing the source of the funds' excess returns is a problem.

Two, bonds are attractive because they have finite life. This helps in creating LDI portfolios. An investor wanting to buy a house five years hence can invest in a five-year bond. Since bonds are redeemed at par, the investor is certain of the cash flows on maturity. Investors buying bond funds, on the other hand, have to redeem the units at the net asset value (NAV). And this makes investment cash flows uncertain, as NAV is dependent on the market price of the bonds.

Three, understanding the yield curve and interest rate environment is necessary to choose bond funds. And since investors are typically acquainted with the equity market than the bond market, choosing the optimal bond fund may be difficult.

Finally, the RBI sets the tone for interest rates.

This offers limited scope for capital appreciation in bonds. An investor would have earned an annualized return of just over 8 per cent in the last 10 years if she had invested in the long-term gilt funds. It is, hence, moot if bond funds are optimal investments.

Conclusion

Given the issues with bond funds, it would be optimal to invest in interest-rate products such as bank fixed-deposits. Such investments would form part of an individual's core portfolio.

These investments offer two benefits. One, they form part of the tax-exempt investments or the portfolio's asset location policy. Two, they have fixed maturity. They do not offer capital appreciation. But returns are comparable with top-performing bond funds.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor learning solutions. He can be reached at >enhancek@gmail.com)

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