Bonds can be hidden gems in your portfolio

The major advantage of investing in bonds is that it helps diversify and grow your money by way of fixed returns as well as capital appreciation. These instruments mainly comprise corporate and sovereign bonds, company fixed deposits, convertible and non-convertible debentures. Bonds do come with a few risks like skewed yield curves, interest rate defaults by corporates, downgrades, reinvestment and rip-off risks. The best way to have bond portfolio is to have a blend of sovereign debt, tax-free preferably and triple 'A' corporate bonds.

Bonds do not make for interesting conversation at dinner parties, nevertheless they are an integral part of any investment portfolios. A common perception about bonds, corporate or government, is that they are meant for the retirees or at best given away as a high school graduation gift from an elder in the family. In a well-diversified investment portfolio, bonds help add a relatively predictable income over time. If you believe in the philosophy that funds should never remain idle even for a day, then bonds can be considered a good investment liquid product too and they are less risky when compared with equities.

The benefit of compounding is often under-estimated by many. For example, a ten-year bond with a fixed return of 12% gives a compounded return of over 200%. So Rs 1,000 invested returns Rs 3,105.85 by the end of the tenure and the interest earned alone is Rs 2,105.85.

The major advantage of investing in bonds is that it helps diversify and grow your money by way of fixed returns as well as capital appreciation. These instruments mainly comprise corporate and sovereign bonds, company fixed deposits, convertible and non-convertible debentures. Bonds do come with a few risks like skewed yield curves, interest rate defaults by corporates, downgrades, reinvestment and rip-off risks. The best way to have bond portfolio is to have a blend of sovereign debt, tax-free preferably and triple 'A' corporate bonds.

It would be worthwhile to route such investments through mutual funds.

One should look at performance ranking, ratio analysis, the fund manager behind your funds, expense ratio and the asset under management while selecting a mutual fund. These are explained below for a better understanding.

Performance ranking: More than the recent or long-term performance of any scheme its ranking among peers should be looked at. One needs to check out the quartile ranking which will show performance quarter on quarter. In quartile ranking, each quartile comprises 25% of peer group schemes. Select the scheme that has remained in the top quartile. If a scheme dips below the 3rd quartile in a couple of consecutive quarters it's a signal to exit.

Ratio analysis: Risk and return ratios like standard deviation, sharpe ratio etc. Along with those ratios, one also should check out the `alpha' of the fund. Alpha tells us what extra or less the fund manager has generated out of a given portfolio in comparison. In other words, `alpha' is the performance ranking of the fund manager. If the fund manager has generated positive `alpha' in last few quarters it's good news. Also watch for consistency, going forward.

Know your fund manager: Though managing funds is process-oriented, the fund manager is the ultimate decision-maker and his view point counts. It is therefore advisable to have a background check of the fund manager. If you realise that a fund has performed poorly on account of a manager-change, then you may want to explore other performing funds.

Total expense ratio: Expense ratio is an important parameter while selecting any mutual fund scheme. All fund management and distribution related expenses are borne by the scheme and therefore the investors. This means high expense ratio will affect the fund's returns.

Assets under management: This parameter is different for debt and equity schemes. In equity the comfortable asset size runs into hundreds crores of rupees while in debt, it would be in thousands of crores. Lower AUM is highly risky as investors are few. The exit of any one big investor will rock the boat adversely. A high scheme assets also help in reducing such shocks as well as the total expense ratio. Keep reviewing periodically, preferably, every quarter.

The writer is vice president-equity advisory group at Motilal Oswal Securities