Your investment decisions involve trade-offs. Should you aim at higher returns with high downside risk? Or should you settle for low risk and lower returns? In this article, we discuss one such decision you face: whether to invest in bank fixed deposits or bond funds for your bond allocation in your core portfolio.

Downside risk

Bonds funds, whether they invest only in government bonds or government and corporate bonds, expose your investments to market risk. This is because investment and redemption prices are at net asset value (NAV) per unit, which is based on market value of the portfolio. The market value of the bond fluctuates based on interest rate expectations. Bond prices are inversely related to interest rates. That is, bond prices go up when interest rate comes down, and bond prices decline when interest rates go up.

Interest rates have a floor — they do not typically go below the inflation level in a country. There is, however, no cap to how much interest rate can rise. Of course, the RBI will take steps to control inflation and interest rates from spiralling. That said, the upside in interest rate is greater than the downside. Because interest rate is inversely related to bond prices, this translates into: the downside in bond prices is greater than the upside.

So, for allocation to bonds as an asset class in core portfolio, should you prefer bond funds or bank deposits? The answer depends on the differential return and risk between the two investment products. Bond funds can offer about 150 basis points more return, assuming an expected pre-tax return of 8.5% on bond funds and 7% on bank deposits. But what if the bond market declines and bond funds give up gains? Also, what if the fund you invest in underperforms its benchmark index and generates lower returns?

Conclusion

Gains on your investments in bond funds are taxed at your marginal tax rate regardless of the holding period, as is your interest income on bank deposits. So, the choice between the two products comes down to only your risk-return preferences. If you prefer stable income products for bond allocation, then you must consider bank deposits. Bank deposits also offer diversification in the source of returns — capital appreciation from equity funds and interest income from deposits. But if you do not mind downside risk, then bond funds should be your choice.

(The author offers training programmes for individuals to manage their personal investments)