I am a long only kind of a portfolio person even though when I look at some companies which are truly big, rich and famous I am tempted to be short – like ITC, LnT, Sbi, Pnb, BoB,…oops all the psu including Icici, Axis, Lic, NIA…but this is a post about bonds is it not?

I need bond funds from liquid to long term bonds. As I go about building some Retirement portfolios. These are people who need to have some money in debt, do not want to see a 2008 in their equity portfolios, and are willing to stay long in bonds (say 10 years). So how does one go about doing this?

What you should know about bonds:

• Bonds can play an important role in your portfolio provided you have finished off paying your home loans, car loans etc.
• If you have a loan, you are better off paying the loans
• Your debt portfolio MUST contain PPF and if you are a senior citizen, SCSS – senior citizens savings scheme
• If you are a 40 year old your parents should have Rs. 30L in SCSS
• All of you in the house should have a PPF – so Rs. 1.5L * 4 i.e. the first 6L of your debt goes there

Once you have done this, you should look at bond funds…

If you have a goal that is 7-10 years away, you should have at least 30-40% in bond funds. I am not likely to suggest more than 60% in a equity fund. Annually you will push some money from an equity fund into a bond fund – as you get nearer to the goal. When you are 2 years away from your goal you should be about 80% in a bond fund, because the next 2 years yield will take you to almost 100% of your goal amount. This is better than cash, and removes the uncertainty of equities especially in the short term.

However, unlike equity a bond fund is far more difficult to choose. If you have a clear 10 year fund requirement, that portion of your money has to go into a 10 year bond fund. Immaterial of what happens to interest rates, you will get your FIXED coupon and maturity proceeds if you pick a good enough bond. Ntpc, Sbi, etc. bonds are available and liquid. HOWEVER, be clear that a 10 year maturity paper will fluctuate, but that should not bother you. Looking it on a day to day basis is a waste of time – its Noise!

Bond funds with known maturity from True to Label fund houses are really true to label. They stick to the stated maturity – this is like owning a whole series of laddered bonds. Makes a lot of sense. If you are not sure what your want invest in high quality corporate bond fund with a 2 year maturity. You will not have to worry too much about the portfolio and interest rate variation will not deplete your fund by too big an amount.

For small bond fund holders interest rates going up (so portfolio value going down) should not be a problem.

We are taught to think that interest rates and bond prices are inversely correlated, but the reality is that rising interest rates cause bond prices to fall in the short-term, but do not impact the long-term coupon payments that that bond is structured to pay. Take, for instance, the case of a 10 year bond with a paying 7% per year. If interest rates rise by 1% every year (make it 0.5% if you want!) that bond still pays you 7% every year plus you get your principal upon maturity. Worrying about the day to day fluctuation is amazingly foolish. Luckily in India bond prices are not available on a ticker – just like a bank fixed deposit does not bother us.

If you have a 3 year requirement, do not buy a 10 year bond hoping to exit in 3 years. That might be tough and the interest rate cycle could hurt you with a bad valuation at sale time. If you have a 5 year requirement, buy a bond which has 5 years to run, and is of a good quality.

Stop worrying too much about inflation. Peg it at 8% for all calculations, and in your own life worry about increasing your income to protect yourself against inflation.