His views are right as bond funds are indeed low risk, but they give dismal returns as well. No, this is not a case against bond funds and there are definitely occasions when they perform well. However, for investors who are in the accumulation phase, it is best to have minimal exposure in them. In fact, they can even afford to give them a complete miss.
Let us take Malhotra's example. He has parked funds that he would possibly need ten years down the road in six funds.
As it can be seen in the table, the returns in the last one to three year timeframe have been in the range of 5 to 7 per cent. Over a five-year period the figures come down further, between 4 to 5.5 per cent. Also, fund management expenses are not too different from equity funds.
The key reasons why bond funds should have a very low allocation in your portfolio:
Low returns: These funds generally deliver lower returns than stocks except during times when interest rates are going down.
Higher expenses: Most of the funds have higher expenses, in the range of 1.4 to 2.1 per cent. This creates a double whammy of higher expenses and low returns.
Hit by tax: Though the tax structure is much more favourable than directly investing in bonds, this is still an additional burden on returns and hence after tax and post expenses, the returns can be very low. This implies that most of the bond funds have a tough time beating inflation post expenses and taxes.
Credit risk: This assumes a lot of significance in the light of the subprime crises that you hear about on every channel. Most of these subprime instruments had been rated by credit rating agencies in the US because only after ratings are issued, will such instruments be bought by pension funds. So this subprime crisis does give us an indicator that not all ratings can be trusted or followed blindly. Just because an instrument is AAA rated might not mean it really is. The point that I am trying to make here is that the possibility of credit risk can never be ruled out.
Additionally, it is very unusual for any bond fund manager to outperform the index by a huge margin because there aren't too many strategies or unique things that he could possibly follow. Higher returns from bond funds can be generated in an era of declining interest rates like the ones we witnessed in early 2000 where bond funds were stellar performers and some even delivered very high double digit returns. However, in an era of stable or rising interest rates, bond funds can only deliver low single digit returns or negative returns.
In other words, as we always say, since timing the market is not something that an individual can achieve, it is best to stay away from investments that require you to time it for great returns.
The writer is director, My Financial advisor
