Living with real assets and bonds in your portfolio
So far, fixed bank deposits (FDs) have been the go-to place for security-conscious investors. For several decades, these were not only relatively safer options, but also inflation-fighting ones.
But only so far is current inflation higher than what the banks are offering as a deposit rate. The problem with this scenario is the depreciation of money.
To elaborate, suppose there is a bag of rice that costs Rs 100, today. As inflation climbs to 7%, the same bag will cost 107 rupees a year later. However, you have money in a FD bank (which pays 5.8%) to buy that rice a year later. You now have a shortfall of Rs 1.2. And that is before FD Bank interest tax which is at the same rate as income tax. Assuming a tax rate of 33%, you have 103.87 rupees after paying tax on interest earned. Obviously, this situation is not ideal and needs to be corrected.
A popular avenue to improve FD returns has been to invest in bonds, which are fairly familiar to most people. They are simply securities that have an annual or semi-annual payment based on a predetermined coupon (interest) rate and these can be freely bought and sold on the bond markets, as well as on stock exchanges.
The rate of return depends on two factors.
a) The risk of the entity issuing the bond: government or GSec bonds present the least risk of default because they are guaranteed by the Reserve Bank of India. Therefore, a safer bond is likely to yield a lower yield for the same residual life of the bond (all bonds have a finite life after which the issuer must return all the money, that is i.e. the face value of the bond, to existing investors).
b) Remaining life – the longer the expected holding period, the higher the probability of something going wrong, hence the expected return (yield) of the bond for the same risk of default of the transmitter.
Choosing the right set of bonds (even from the same banks that issue term deposits) can help offset some of the effects of inflation. The catch will be some understanding of the market and a choice between residual life as well as risk (using government issued ones as well as corporate ones). We can also use the same logic with ETFs (equity-traded funds) even if choosing the dividend option is perhaps not ideal.
However, sometimes this may not be enough or may not meet income needs, i.e. some people may want income in the wallet for the purpose of spending money or just making a profit .
One of the recent financial innovations is the real asset. They are generally physical products (as opposed to financial products) with one characteristic in common with bonds: there is a regular payment. However, unlike bonds, this payment can be variable. For example, a company owns a few office buildings that are leased. 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 shares of the trust (like a mutual fund) and thus participate in the distribution of rental income as well as capital gains. values from increased land/building value.
Similarly, the same is possible for other assets such as toll roads and power transmission in another investment called InVit or Infrastructure Investment Trust. Since there are no REIT or InVits funds yet, it would be prudent to invest in a few of these to diversify issuer and investment risk.
Thus, adding these instruments to an equity portfolio is a good strategy to diversify equity market risk and at the same time generate modest cash flows while maintaining portfolio liquidity. Allocation percentages depend on broader portfolio objectives, cash flow and investor risk aversion.