There are bond investment platforms that let retail investors buy bonds directly. Many of these platforms sell high yield bonds issued by private organisations. For debt/bond allocation in a long-term portfolio, can investors buy these bonds?
As an example, let’s look at this high yield bond that pays 10.75% fixed coupon, but available in the market at the yield of 11.415%. (This is just a random example; not a recommendation for/against investing in this bond.)
 |
| Screenshot from goldenpi.com |
When I calculated the XIRR for this bond, it came out to an impressive 11.72%. But that’s before accounting for tax. Advance tax is due every quarter on the interest received, so let’s assume that we set aside the cash necessary to pay the tax as soon as we receive the interest. That causes the XIRR to drop.
 |
| Effective XIRR of the bond for 30% tax + various surcharge rates (source) |
Some of you may point out that the after-tax XIRR of 7+% is actually great from a fixed income instrument. You are right, but we need to look beyond (the admittedly attractive) XIRR the following reasons:
- Investments with high XIRR are useful only if you can reinvest the incoming cash quickly. If the interest piles up in a savings bank account, you are not benefitting from the high XIRR. (See Don’t let attractive XIRR figures fool you.)
- These bonds usually have so little demand in the market that these bonds are held till maturity in practice. When the interest rate falls, you don’t benefit from the increase in the bond price. There is no inverse correlation with equity in practice.
- This means that you cannot rebalance your portfolio by selling bonds to buy equity. The bonds need to stand on their own, and cannot be part of a portfolio diversified across asset classes.
- A bond mutual fund that holds higher quality bonds, however, can be a great addition to a diversified portfolio. Such a fund may have a lower yield, but it’ll be liquid enough to be useful at all times.
- When you invest in a bond mutual fund, you can defer taxation until redemption. This could be years or even decades for a long-term investor. This will increase the effective after-tax return for those investors.
- Gains made from bond mutual funds are considered capital gain. Capital gain arising from bond mutual funds can be offset by short-term capital losses. No such benefit for the interest earned through holding bonds directly.
- If the bond issuer goes bankrupt and the bond value becomes zero, that may count as capital loss, but I don’t know the tax rules around it.
- A sovereign bond, which has virtually no credit risk, will likely give around 7% pre-tax yield. Consider holding a gilt mutual fund for 15 years. Your returns will be pretty good at a much lower risk. If we consider the risk-adjusted return, isn’t a gilt fund a much better choice for most retail investors?
I’ll likely buy a low-quality high-yield bond to hold in my fun portfolio. But that’s mostly for the cheap thrill of investing in this asset. Such bonds have no place in my more serious portfolios.
