Corporate Bond Funds : Risks, Returns and Suitability

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You need to understand that mutual funds do not invest only in equities but also in debt instruments. Investors should choose only those mutual funds that are in sync with their risk profile. This article gives information about corporate bond funds – a category of debt fund schemes.

Corporate Bond Debt Funds

Any company can issue corporate bonds, also called Non-Convertible Debentures (NCDs). Organisations or firms need capital for their daily operations as well as future expansions and growth opportunities. To achieve this, companies have two ways – debt and equity instruments. Debt is a safer option as it doesn’t affect the shareholders of the company directly. Hence, most companies prefer issuing debt instruments to raise capital for their operation. Depending on their needs, bank loans can be expensive for corporations. This is where bonds or debentures provide companies with an economical alternative to raise funds. Corporate bond securities are the underlying portfolios of credit opportunities for debt funds. When you purchase a bond, the company is borrowing money from you. The firm will repay the principal after the maturity period as mentioned on the agreement. In the meantime, you will receive the interest (fixed income) – known as the coupon. Generally, coupon payments in India are made twice a year.

Who should invest in corporate bonds?

Corporate bonds are an excellent choice for investors looking for a fixed but higher income from a safe option. Corporate bonds are a low-risk investment vehicle when compared to debt funds as it ensures capital protection. However, these bonds are not entirely safe. If you opt for corporate bond funds that invest in high-quality debt instruments, then it can serve your financial goals better. Long-term debt funds often tend to become riskier when interest rates fluctuate beyond expectations. As a result, corporate bond funds invest in scrips to combat volatility. They usually go for an investment horizon of one year to four years. This can be an added benefit if you remain invested for up to three years. It can also prove to be more tax-efficient if you fall in the highest income tax slab.

Features & benefits of corporate bond funds

Components of corporate bonds

Corporate bond funds invest predominantly in debt papers. Companies issue debt papers, which include bonds, debentures, commercial papers, and structured obligations. All of these components carry a unique risk profile, and the maturity date also varies.

Price of the bond

Every bond has a price, and it is dynamic. You can buy the same bond at different prices, based on the time you choose to buy. Investors should check how it varies from the par value – it will give information about the market movement.

Par Value of the bond

This is the amount the company (bond issuer) pays you when the bond matures. It is the loan principal. In India, a corporate bond’s par value is usually Rs 1,000.

Coupon (interest)

When you buy a bond, the company will payout interest regularly until you exit the corporate bond or the bond matures. This interest is called the coupon, which is a certain percentage of the par value.

Current Yield

The annual returns you make from the bond is called the current yield. For example, if the coupon rate of a bond with Rs 1,000 par value is 20%, then the issuer pays Rs 200 as the interest per year.

Yield to Maturity (YTM)

This is the in-house rate of returns of all the cash-flows in the bond, the current bond price, the coupon payments until maturity and the principal. Greater the YTM, higher will be your returns and vice versa.

Tax-efficiency

If you are holding your corporate bond fund for less than three years, then you must pay short-term capital gains tax (STCG) based on your tax slab. On the other hand, Section 112 of the Indian Income Tax mandates 20% tax on long-term capital gains. This applies to those who hold the bond for more than three years.

Exposure & allocation

Corporate bond funds, sometimes, do take small exposures to government securities as well. But they do so only when no suitable opportunities in the credit space are available. On average, corporate bond funds will have approximately 5.22% allocation to sovereign fixed income.

Risk factors & returns

There’s always the possibility of bond issuers defaulting on their obligations. This default risk is higher for low-rated securities and goes up exponentially with increasing maturities. If your fund manager invests only in highly-rated companies, expect an average return in the range of 8% to 10%. Here, the risk is also minimal. On the other hand, if you invest in a slightly low-rated but a well-managed fund, then it can be rewarding. For instance, companies tend to give somewhat higher coupon rates to attract investors. However, there is also a chance that the fund manager’s call on a company going wrong. Hence, if a company defaults on interest payments or principal repayment or the company gets downgraded further, then it is a setback for investors.

DID YOU KNOW?

Always check the Yield to Maturity or YTM because higher the YTM, greater will be the returns and vice-versa.

How do corporate bonds make returns?

There is a debt market where several bonds are traded. In this market, the prices of different bonds can rise or fall, as they do on the stock markets. For instance, a mutual fund buys a bond, and its price subsequently rises. Then, it can make additional money over and above what it would have made out of the interest income alone. However, it could also go the other way.

Types of corporate bond funds

Broadly, there are two types of corporate bond funds.

  • Type One: Type one corporate bonds invest in high-rated companies – public sector unit (PSU) companies and banks.
  • Type Two: Type two corporate bonds invest in slightly lower rated companies such as ‘AA-‘ and below. Let’s take a simple example to understand this. Suppose, a CRISIL “A” rated bond with 1-year residual maturity has a 0.56% chance of defaulting and a CRISIL “A” rated bond with a 3-year residual maturity has a 4.79% chance of defaulting. Generally, corporate bond funds allocate at least half their portfolios to bonds with AA rank or lower. So, there’s always the risk of some or the other bond in the portfolio defaulting, resulting in the drag-down of portfolio returns.

Top Corporate Bond Funds in India

Bond Fund3 year5 years
SBI Magnum Constant Maturity Fund10.63%10.65%
ICICI Prudential Constant Maturity Gilt Growth  10.36%10.88%
L&T Triple Ace Bond Fund Growth9.55%8.81%

Things to remember before investing in Corporate Bond Funds

  • Corporate bond funds invest in corporate debenture and bonds of medium to long-term tenure. So, look at it as a long-term investment vehicle
  • Some market knowledge is essential here. If you are not a seasoned debt fund investor, then it will be challenging to understand potential risks and market
  • Remember that a large number of defaults within a fund’s portfolio can lead to a severe drag in returns. If you decide to invest in them, then don’t let past-year returns influence your decision
  • In the case of corporate bond funds, it is better to stick to the offerings of large AMCs, preferably, the top five funds. Otherwise, new investors would be better off sticking with high-rated short-term debt funds with lower credit risk.  

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