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Rising Interest Rates: How To Construct A Fixed-Income / Bond Portfolio?

by Tavaga Invest
Bond Investment

By: Tavaga Research

Investors often ignore investing in debt instruments such as fixed deposits, bonds, and debt mutual funds when there is a boom mentality in the equity markets. This phenomenon was seen especially during (and post) Covid-19 when a large number of Indian retail investors migrated from investing in FDs to investing in mutual funds and direct equity markets due to a low-interest rate regime and attractive valuations of India’s broad indices compared to global peers. Just to give context, an average of 25 lakh new demat cum trading accounts were opened every month in the financial year ending March 2022 as against 4 lakh accounts in FY 2020 (pre-Covid).

While it is true that this led to the financialization of savings at the right places with the potential for superior returns, investors today, especially millennials are wary of investing in fixed-income instruments which offer a single-digit return as against the equities which have generated close to 15% annualized return over longer investment horizons in the past.

Staying ahead of inflation doesn’t always mean buying only the equity-oriented instruments as there is sufficient evidence of the past that denotes sub-par or flat returns in equity instruments as well. The optimal way to go forward is to have the right asset allocation model as per the risk appetite and goals of an investor.

Team Tavaga, therefore, believes that equity is important for long-term superior returns along with a sizeable allocation to fixed-income instruments, especially during a rising interest rate regime.

Various modes to invest in fixed-income instruments

Target Maturity Index Funds and ETFs 

Target maturity debt funds are passively managed debt funds with a defined maturity. A target maturity fund has features of a bond that has been issued by the central or state governments or corporates but the buying happens through a low-cost mutual fund where the simple strategy that an investor follows is ‘Buy and Hold (till maturity)’. Instead of buying a single bond, the asset management company invests in a collection of bonds thus helping in diversification. In India, there are target maturity funds that take exposure of G-Secs, state development loans, and Public sector companies (PSUs including public sector banks).

By buying a target maturity fund, an investor locks in an interest rate and benefits from it despite any deterioration in the broader economy but only if it is held till maturity. Target maturity funds are liquid, there is no lock-in and these are open-ended funds with low expense ratios

Target maturity funds differ significantly from other active mutual funds such as gilt funds, medium duration funds, and banking and PSU debt funds. In actively managed mutual funds, an investor must take care of the entry and exit points while investing as there is no defined maturity of the fund. However, with target maturity debt funds, an investor gets to lock in a return if held till maturity.

With target maturity ETFs such as the Bharat Bond ETF, an investor must consider the liquidity component as well before executing a lumpsum transaction. While AMCs ensure enough liquidity through market makers, it is always better to check the order book before executing the transaction.

Target Maturity FundExpense RatioActive Mutual FundExpense Ratio
Edelweiss Crisil PSU Plus SDL 50:50 Oct 2025 Index Fund0.17%SBI Magnum Medium Duration Fund0.69%
Edelweiss Nifty PSU Plus SDL 50:50 April 2027 Index Fund0.16%ICICI Pru Banking & PSU Debt Fund0.35%
Bharat Bond ETF0.0005%DSP Government Securities Fund0.54%

Buying a bond

Many fintech companies have now come up with an option for investors to assist them in buying bonds from the open market or the auctions conducted by the RBI. In simple terms, an investor can buy a bond, like he/she purchases a stock. However, the process is different, and the risks attached to the same are different. The settlement of a bond instrument happens on T+0 days (that is, the bond gets credited to the demat account and the funds are debited from the bank account on the same day). Unlike equities, where equity stock settlement happens on a T+1 basis.

Some issues by companies or by governments require a big ticket size which can go as high as Rs. 10 lakh per bond. However, the regulator and the bond issuers have made the process pretty smooth for a retail investor by reducing the ticket size of a bond to as low as Rs. 1,000 per unit. 

In order to help investors participate in the direct bond market, the RBI launched the RBI Retail Direct Scheme in 2021 allowing them to access the primary and secondary debt market. Investors can now easily purchase and sell government/RBI-issued bonds through the open market. The RBI has ensured that the customer onboarding process is easy making it a viable option for investors to trade in debt securities and increase its liquidity. 

A treasury bill was recently placed under auction by the RBI with a yield (yield is the true interest rate an investor gets on bond maturity) of 7.00% and a maturity of 364 days. Even in the current rising interest-rate scenario, it has become difficult for a millennial to buy a fixed-income instrument with a yield of 7.00%.

However, achieving diversification becomes difficult by buying a single bond. The investor will have to purchase bonds with different maturities and different issuers. While diversification plays a key role in equity markets which are exposed to market risk, with a G-Sec bond or a treasury bill, there is no credit risk involved and no price risk either if held till maturity. There is no chance of a capital loss as the bond is always pulled to par at the end of maturity.

Moreover, there is no brokerage component involved while purchasing bonds. However, if buying from an open market, the investor must ensure that there is enough liquidity to execute the transaction. Therefore if an investor gets the perfect bond as per his/her goals and objectives, this is an inexpensive mode to get fixed-income exposure.

Buying an active mutual fund

An actively managed debt fund is similar to any other actively managed equity fund with various categories. The only difference is the instrument type, which is an actively managed debt fund that has bonds in the portfolio and not equity stocks. Actively managed mutual funds are comparatively expensive (higher expense ratio) than the target maturity debt funds. Moreover, the fund manager is exposed to behavioral biases while selecting bonds for the actively managed portfolio. 

A credit risk fund, which had gained popularity in the past due to its high returns is one of the best examples of why an investor should generally avoid an actively managed debt fund unless there is no alternative to it. The Franklin Templeton Mutual Fund episode is still fresh in the minds of investors who couldn’t liquidate their holdings because of some alleged wrongdoings. Thankfully, all the investors got their money back but albeit after the intervention of the SEBI.

An actively managed debt fund can do wonders for investors who only wish to invest in debt instruments for the short term (less than 3 years). There is hardly any lock-in, the expense ratio is low, and maximum investments are into treasury bills and bonds with near-term maturity. Moreover, the fund manager does not take many risks in this portfolio as there are high liquidity requirements. However, buying a short-term debt fund is tax inefficient. Instead, an equity arbitrage fund is a better option for investors having a time horizon of fewer than 3 years. If the time horizon is between 2-3 years, an equity hybrid fund or an equity savings fund can also be considered (but the disadvantage is the high expense ratio compared to an arbitrage fund).


Fixed deposits are only recommended to investors who prefer to sit outside the ambit of Indian capital markets. Otherwise, a fixed deposit is the most tax-inefficient instrument for an investor, especially one in the 30% tax bracket. 

The interest income from a fixed deposit is added to the annual income. So if a person falls in the 30% tax bracket, the interest income from a fixed deposit scheme will be taxed at a whopping 30%. Therefore, it remains best to avoid fixed deposits.

Fixed Deposit Rates as of November 2022 (Ranging from 7 days to 3 years)

Bank NameGeneral citizensSenior citizens
HDFC Bank3.00% to 6.20%3.50% – 6.95%
State bank of India3.00% to 6.10%3.50% – 6.90%
Kotak Mahinda Bank2.50% to 5.90%3.00% – 6.40%
Canara Bank3.25% to 7.00%3.25% to 7.50%
Punjab National Bank3.50% to 7.00%4.00% – 7.80%

The ideal way to construct a fixed-income portfolio

To cut the long story short…

  1. Subscribe to the services of a SEBI Registered Investment Advisor specializing in financial planning and not only recommending equity stocks
  2. Make a list of all the goals in life
  3. Determine the risk appetite 
  4. Build a fixed-income portfolio with a target maturity fund
  5. If a particular target maturity fund is unavailable as per the time horizon, ask the advisor for bonds in the open market 
  6. For short-term goals (less than 3 years) keep minimum exposure to equity instruments, irrespective of risk appetite

Recent Development in the Indian Bond Market

To further improve the liquidity in the corporate bond market, SEBI on recommendations and representations of various capital market participants has reduced the face value of debt securities from the current Rs. 10 lakh to Rs. 1 lakh for private placements (in short, reduced the minimum investment from Rs. 10 lakh to Rs. 1 lakh).

Remember: Fixed Income is a fantastic asset class, it can help investors in beating inflation and also help them stay away from volatility unlike other asset classes such as public equity and private equity. Yes, fixed income can be boring, but sometimes, BORING IS GOOD!

Team Tavaga will be more than happy to help you in constructing a portfolio to cater to your financial goals!

Disclaimer: Above piece is only for information purposes. No recommendation, consult your investment advisor.

Tavaga is everything you need to start saving for your goals, stay on track, and achieve them in time. 

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