Do you have a healthy investment portfolio? Are you taking the right amount of risk to generate your desired returns or you are yet to be there? If these are the question that you ask yourself, you need to revisit your portfolio’s asset allocation and evaluate the risk and return ratio once again. Having a healthy investment portfolio means striking the right balance between the risk that you can take and the return you are expecting.
While some asset classes may offer higher returns like equities, you also need fixed-income assets to balance the risk. One such fixed-income instrument is a Bond which you can include in your investment portfolio to minimize the risk and optimize the return.
Global bond markets were approximately at $128.3 trillion (as of August 2020). It is one of the biggest markets when it comes to debt investments. If you want to include bonds in your portfolio, then you have innumerable options to do so. This article will help you understand how bonds help you build a healthy portfolio of assets.
What is a bond?
Bonds are debt investment products that are issued by a government or corporate houses to raise capital. The person who buys the bond lends money to the issuer, against which he receives an interest (coupon) and the principal is redeemed upon maturity. There are broadly two types of bonds – government bonds where the government raises capital and corporate bonds where corporate houses raise capital.
How does a bond work?
Let’s take an example to understand how a bond works. Suppose you are buying a government bond (GOI bond) that has been issued at Rs. 1000 per bond. This Rs. 1000 is the face value of the bond. GOI is offering a 4% interest rate on this bond which will be paid annually. The maturity of the bond is fixed at 5 years.
So, for the five years, you will receive the interest at the rate of 4% on the face value of the bond, every year, and upon maturity, you will receive the Rs. 1000 as well.
Coupon received every year is = 4%*1000 = Rs. 40
The interest rate or coupon on the bond doesn’t get affected by the market interest rate. Whether the repo rate increase or decreases, the 4% coupon on this bond will be fixed. Another thing to keep in mind is that even if the price of the bond changes, then also the coupon will be fixed.
This leads to the difference between the coupon and the yield of a bond. While your coupon can be 4% on this bond mentioned above, the yield of the bond can be different. Now, there are different yields as well, for instance, the current yield is derived by dividing the bond's coupon by the current price. If the current price is higher than the face value, the yield will be lesser than the coupon rate and vice versa.
What makes bonds so attractive investment options?
The global bond market is so huge because of the following reasons –
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Bonds help investors earn regular income
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By investing in the bonds, your capital is preserved especially if you are investing in government bonds as they have very low to a nil risk factor.
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If there is an economic slowdown, bond income becomes more attractive as you know that you will receive a certain amount from it even though the market is sluggish.
How much you should invest in bonds to have a healthy investment portfolio?
Your investment plan must include bonds to have the right balance between risk and return. Bonds help in hedging against market volatility, however, the question is how much you should invest in bonds to strike that right balance.
So, it should be according to your –
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Age
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Risk appetite
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Investment goals
Suppose you are young, just started with your career, your risk appetite is usually high at this age, and have long-term investment goals. Then your investment portfolio can have somewhere between 25% to 30% of debt instruments which should include bonds.
As the age increases, you would look for stable returns, regular income, and risk appetite goes down, so the percentage of bond investment can go up accordingly.
To invest in bonds, you need to check with your mutual fund distributor which bond they offer.
Final thoughts
While investing is essential, investing in the right assets is important. Whether you are a risk-taker or risk-averse investor, having a certain percentage of bonds in your investment portfolio can help you during unfavourable economic conditions.