I had done an article saying ‘Fixed deposits or Debt funds?’ a few months back.

Now I am asking a question again:

Bonds or Bond fund?

Recently there have been a spate of bond issues by PSUs and they all have been at attractive yields. When I argued in FD v Debt fund, the argument was for a tax free compounding in debt funds.

However in case of TAX FREE DEBT BONDS, that argument flies out of the window. So for a person with a net worth of say Rs. 20 million and wishing to invest say Rs. 2.5 million, the best thing is to invest Rs. 0.5 million in 5 bonds. Most of them pay interest on a six monthly basis, but at worst they could be paying on an annual basis!

As long as you want to use this money for your expenses or investing in say equity funds, you do not have to worry about the FLUCTUATION in price. It is safe to assume that these bonds do not have a default risk, but will fluctuate in price if the interest rate varies. Assuming that interest rates drop, the value of these bonds will go up, but if interest rates go up the bond prices will drop.

I would not worry TOO MUCH about interest rates going up too much. Sure, there is a risk that interest rates go up say 1% p.a (100 basis points) from here, but that could create a 20% drop in the value of the bond!! This is because these are bonds with a longish duration – and hence the dramatic impact. However if you are NOT PLANNING to sell these bonds in a panic, YOU should be adding more bonds.

Surely people need to understand the following risks:

1. Liquidity:

all these bonds are listed and are supposed to be traded, but the market may not have too much depth on the day you want.

2. Interest rates go up and remain there:

this is a big risk of hyperinflation – say it stays at 12% for 5 years – this will rip the value down.

3. Interest default, Interest delay and Principal default:

if the government changes some law somewhere by which the risk of these balance sheets are shifted from the government to the companies themselves, these bonds will become worthless.

The interest being at 9% p.a. I do think the risk is worth taking. However you should invest about 20% of your debt portfolio into such schemes. Your total debt investment would anyway be in Public Provident fund, LiC policies (do not buy new, but if you have them and are too emotional to surrender it!), etc.