For Indian investors, an all-bond portfolio is an essential ingredient in the development of a plan for financial independence. Hildy Richelson, a bond expert and President of US-based Scarsdale Investment Group in an email interview to FE’s Saikat Neogi says, for a buy-and-hold type of investor, investing in bonds is about creating a cash flow for income and the reinvestment of principal.
Conventional wisdom says investors need to strike a comfortable balance between risk tolerance and return expectations. Do you think, in the wake of the 2008 financial crises, that conventional wisdom is changing?
We do not believe in diversifying assets to anything riskier than high-quality bonds. Historically, investors seem to have a great tolerance for risk until they lose money. Stock investments, for example, are promoted with the idea that, in the long run, investors will have returns that exceed the return on bonds. When markets are very volatile, the belief that if you stay invested, your retirement will be secure appears unrealistic. How does a person know that when he is ready to retire, the stock market will consistently reward him with rising prices? Fixed-income investments are more predictable. If an investor purchases high-quality individual bonds, then he will have a cash flow from the bonds as well as a return of their principal at a specific time.
For a risk-averse investor, will an all-bond portfolio be a surefooted strategy to ensure results? How do you see that in the Indian context?
For a resident of India, the all-bond portfolio is an essential ingredient in the development of a plan for financial independence, which we define as more income coming in than going out. It is important to emphasise that high-quality individual bonds can enable anyone with a mindset to achieve financial independence to do so. In fact, in our book Bonds: The Unbeaten Path to Secure Investment Growth, we explain why we prefer individual bonds to bond funds, which we consider to be quasi-stock investments.
Since credit default swaps (CDS) have recently been introduced by the RBI, bond buyers should consider how they might affect the repayment of their bonds. Though CDS are supposed to help issuers manage their debt, it seems that there are often unfortunate results. In the US, it is not unusual that small and large issuers are frequently misled by the investment banks about the value of derivatives. The issuers then find themselves owing large amounts to the bank, rather than saving millions of dollars.
Various studies show that equities give better returns in the long run. Given the increasing volatility in equities, do you think that will become a myth in the years to come?
In the US, over the last 10, 20, 30 and 40 years, bonds (as represented by US treasury bonds) have outperformed stocks (as represented by the S&P 500 Index). The two crashes in 2000 and 2008 have changed the stock versus bond comparisons. For an individual buy-and-hold investor, investing in bonds is about creating a cash flow for income and the reinvestment of principal. It is not about trading. When we think about selling, we ask ourselves: What else might I do with the cash? If you have a mortgage to pay off, or you have a business that needs capital, then it might make sense to sell your appreciated bonds. If you are not living on the income from your bonds, then you have cash flow that you can reinvest at higher rates in the event of inflation, in effect income-averaging to better returns. The question is not: Which horse do you want to ride, stocks or bonds? The question is: Do I want to speculate and gamble, or do I want to create a cash flow that might lead to financial independence?
Apart from structured products, what are the important factors that an investor should look at before investing in bonds?
Most importantly, an investor should consider the issuer’s ability and willingness to repay its debt. In this regard, larger issuers that draw resources from many sources are usually a better bet than a small issuer that has limited resources. If bonds are callable, then the investor needs to consider if the yield-to-call is acceptable first before considering yield-to-maturity. If the coupon is low compared to newer issued bonds, then the consideration is reversed: yield-to-maturity then becomes more important. Also, the investor should consider if he can hold the bonds until they mature so he does not have to sell, incur additional transaction costs, and possible losses.
How can investors maximise their returns on bonds in the long term?
Investors can maximise their returns on bonds by buying only high-quality bonds, minimising their transaction costs and not losing any money. They should target the maturity dates of the bonds to times when they want the principal returned to them. They should reinvest the interest at the most attractive rates, keeping in mind that their principal needs to be protected.
How do you think the power of compounding works best in bonds?
The power of compounding works best when an investor doesn’t try to time the markets. After the stock market fallout in 2008 and 2009, the financial advisors in the US knew that we would have a massive inflation.
They invested client funds in bonds maturing in less than five years. However, instead of inflation, we have had declining interest rates. We look at inflation as the upside case because you are able to reinvest the interest and principal payments at higher rates. Too much inflation, of course, is not good because it erodes the value of everything.