You need to diversify with bonds too

In the last two weeks, we discussed why you should identify and prioritise your goals and frame investment rules to achieve them instead of spending too much effort in seeking to diversify your portfolio. In response to our discussion, we received responses from several readers who argued that bond investments have to be diversified to reduce risk. We agree. In this article, we clarify our stand on diversification and show how you can adopt simple rules to diversify your bond investments.

Bond diversification?

Our discussion on diversification during the last two weeks pertained to stocks, not bonds. Nevertheless, our stand on bond diversification is somewhat similar. Bond prices are driven by two factors — changes in interest rates and credit risk. Now, bond prices fall when interest rates go up. Likewise, bond prices increase when interest rates decline. This inverse relationship between price and interest rate is the same whether you hold a Government bond or AAA-rated corporate bond. Of course, the magnitude of the price change would be different for each bond.

But you need not be concerned about your bond investments falling in value because of interest rate increases. Why? We want you to match the maturity of your bond investment with your investment horizon. That is, if you have a 10-year investment horizon, you should invest in bonds that mature 10 years hence. This means you will get back your initial capital on maturity of the bond, whether interest rates increase or decrease.

But you have another risk to contend with. What if the bond issuer does not repay your initial capital on maturity? If you have invested in a single issuer, you stand to lose everything if the issuer defaults. Your objective, hence, would be to diversify your bond investments to reduce the risk that you may not get back your initial capital on maturity of the investment. The question is: How should you diversify issuer risk?

Diversifying issuer

Given the requirement to map maturity with investment horizon, your choice of bond investments can be clearly defined — bank fixed deposits for investments horizon up to 10 years, public provident fund for 15-year horizon and tax-free bonds for horizon between 10 and 20 years. It is sufficient to know that the requirement to map maturity and investment horizon precludes investments in both open-end and closed-end bond funds.

Indeed, the credit risk that you assume by investing in public-sector bonds, tax-free bonds issued by Government companies and PPF is low. Nevertheless, it is better that you invest in more than two issuers.

Again, using the same logic that we did for stocks, your bond investment should not be driven by the need to diversify. Rather, you should invest to achieve your objectives and in the process diversify your credit risk.

Towards achieving this objective, you should first exhaust your PPF limit to claim the tax exemption applicable under law. Then, split your bond investments into two categories — lump-sum investment and monthly investment. You should seek to invest in tax-free bonds to meet your lump-sum bond investments. Your monthly investment should be in the form of recurring deposit in two or more banks. You can also choose to make lump-sum investment in bank fixed deposits.

Note that the above bond investment approach serves two purposes. One, it helps you make tax-efficient investments. And two, it helps you diversify your bond investments’ credit risk.

Time and effort

We continue to believe that you should not devote too much time and effort to diversifying your investment portfolio. With equity investment, you can achieve simple diversification by buying index funds and ETFs. For your bond investments, it is important that you invest in more than one issuer to reduce credit risk. And because of your choice of investments, diversifying bonds can be uncomplicated.

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