Cohabiting with real assets and bonds in your portfolio

So far bank fixed deposits (FD) have been the go-to place for safety-conscious investors. For several decades these were not just relatively safer options, they were also inflation-beating.

But that is only until now when the current inflation is higher than what banks are offering as deposit rates. The problem with this scenario is depreciating money.

To elaborate, let us assume there is a bag of rice which costs Rs 100, today. As inflation creeps in at 7%, the same bag will cost Rs 107 one year down the line. However, you have money in a bank FD (which is paying 5.8%) to buy this rice one year down the line. Now you have a shortfall of Rs 1.2. And that is before tax on Bank FD interest which is at the same rate as income tax. Assuming a 33% tax rate, you have Rs.103.87 after paying tax on the interest earned. Clearly, this is not an ideal situation and needs to be corrected.

A popular avenue to better FD returns has been investing in bonds, which are quite familiar to most people. These are simply securities which have an annual or semi-annual payout based on a pre-decided coupon (interest) rate and these can be freely bought and sold in bond markets, as well as stock exchanges.

The rate of return depends on two factors.

a) The risk of the entity issuing the bond: Government bonds or GSecs carry the least amount of default risk as these are guaranteed by the Reserve Bank of India. Consequently, a safer bond is likely to give a lower return for the same residual life of the bond (all bonds have finite life after which the issuer must return all money i.e., the face value of the bond, to existing investors).

b) Residual life - the longer the expected holding period, the higher the probability of something going wrong therefore the expectation of returns (yield) on the bond for the same risk of default by the issuer.

Choosing a suitable set of bonds (even from the same banks which issue fixed deposits) can help offset some of the effects of inflation. The catch will be some understanding of the market and choosing across residual life as well as riskiness (using those issued by the government as well as those by companies). One can also use the same logic with ETFs (equity-traded funds) although choosing the dividend option may not be ideal.

However, sometimes this may not be sufficient or satisfy income needs i.e., some people may want income in the portfolio for the purpose of spending the money or simply to book some profits.

One of the recent financial innovations is real assets. These are typically physical (as opposed to financial) products with one feature in common with bonds – there is a regular payout. However, unlike bonds, this payout may be variable. For example, a company owns a few office buildings which are rented. They would like to expand their business and need fresh capital. They will, therefore, sell the building to a trust (a Real Estate Investment Trust - REIT) where investors can buy units of the trust (like a mutual fund) thereby partake in rental income distribution as well as capital gains accruing from increasing land/building value.

Similarly, the same is possible for other assets like toll roads and power transmission in another investment called an InVit or an Infrastructure Investment Trust. Given there are no funds of REITs or InVits yet, it would be prudent to invest in a few of these to diversify issuer as well investment risk.

Thus, adding these instruments to a stock portfolio is a good strategy to diversify equity market risk and at the same time generate modest cashflows while retaining portfolio liquidity. Allocation percentages depend on larger portfolio goals, cashflows and investor risk aversion.