Investment in Corporate Bond Funds – [Risk and Return]

Risk and Returns of Corportae Bonds - TradeSmart

Every investor looks for certain stability in their investment portfolio. Especially, when you approach your financial goals, you would need your portfolio to be more stable and generate a steady stream of income. Corporate bonds are an excellent investment option to reduce the risk of capital loss, earn a steady income and balance out the stock market volatility effect on your overall investment portfolio. Let’s understand more about corporate bonds.

What are Corporate Bond Funds?

A corporate bond is a debt instrument that offers a higher yield and is issued by companies to raise money. The raising of money could be for the purpose of business expansion, business growth and purchasing new equipment, etc. That means investors who buy these bonds are lending money to the businesses issuing these bonds. The issuer makes a legal commitment to the investor to pay interest on the amount invested. Amount invested/ principal is paid back on the maturity of these bonds.

For example, let’s assume you invest in a 10-year corporate bond with a face value of Rs. 1,000 paying 5% coupon interest. Then, the bond issuer will pay you Rs. 50 per year and pay you back Rs. 1,000 on maturity i.e. at the end of the 10th year. Generally, in India interest payments are made every six months on corporate bonds.

What are the types of Corporate Bond funds?

There are various types of corporate bonds available and the interest payment will vary depending on the types of bond that you invest in.

Here are some of the corporate bond types depending on the interest payment –

  1. Fixed-rate bonds: These bonds pay a fixed rate of interest throughout their term regardless of the interest rate changes in the market. These are also known as coupon rate bonds.
  2. Floating rate bonds: Rate of interest in these bonds vary periodically depending on the interest rate changes in the market. Basically, these are based on benchmarks such as bond index.
  3. Zero-coupon bonds: These bonds pay no interest and the Lump Sum will be paid out on maturity which is higher than the initial investment. Trading Account

Who Should Invest in Corporate Bonds?

Corporate bonds are low-risk investment avenues as they are fixed-income bearing securities and ensure capital protection. Conservative investors or risk-averse investors looking for relatively higher returns on their investment and a steady income flow can ideally invest in corporate bonds. However, corporate bonds also carry higher credit risk as bond issuers may default in payment. Credit rating is an important consideration while investing in corporate bonds as you can evaluate the risk of these bonds based on the credit ratings. Credit rating agencies periodically review the bond issuer and rate them accordingly. Companies with high credit ratings will carry a negligible risk of default. 

How to Invest in Corporate Bonds?

There are mainly three ways in which you can invest in corporate bonds in India. Let’s take a look at these routes for investing in corporate bonds

  • Primary issue
    Primary issue or new issue bonds are offered newly by the companies that are looking to raise the money. You can invest in these primary issuances of bonds directly by filling in the application form and making a payment to the issuer. If you have a Demat account, you can buy corporate bonds through brokers or intermediaries. When investing during the offer period, you will pay the face value. You have to thoroughly research the company background and its credibility, assess the risk before investing in the primary issuance of bonds. You can choose the bonds with a maturity period that suits your requirement. Once you purchase corporate bonds through a primary issue and hold it through maturity, then there is no yearly cost involved for this investment.
  • Secondary market
    Many corporate bonds are also traded over the exchange. Retail investors can also buy and sell from the secondary market. Corporate bonds that are bought in the primary market can subsequently be sold in the secondary market. You can buy them in the secondary market as there will be some investors who have purchased in the primary market who would be looking to sell before maturity. While buying corporate bonds in the secondary market, you need to mainly look at the price and the yield of the bond.
  • Corporate bond funds
    One of the most popular ways to invest in corporate bonds is to invest through corporate bond funds. Unlike primary issue and secondary market purchase which is more of a do-it-yourself method to invest in corporate bonds, a mutual fund route is more convenient as it offers flexibility, liquidity and professional management of your investment. Corporate bond funds are a type of debt mutual fund that invests 80% of its corpus into corporate bonds. Basically, there are two types of corporate bond funds available in the Indian mutual fund market. The type one corporate bond funds invest majorly into corporate bonds of top-rated companies with the highest possible credit ratings. These are mainly banks and public sector companies. The type two corporate bond funds invest in corporate bonds of companies with slightly lower credit ratings such as companies rated ‘AA-‘ by CRISIL or any other well-known credit rating agency.Here are some of the best corporate bond funds –

 

Fund Name 3-year return 5-year return
Kotak Corporate Bond Fund 9.53% 8.98%
Aditya Birla Sun Life Corporate Bond Fund 10.37% 9.37%
IDFC Corporate Bond Fund 9.58% NA
ICICI Prudential Corporate Bond Fund 9.90% 9.05%
HDFC Corporate Bond Fund 10.38% 9.38%

 

Risks of Corporate Bonds

Although corporate bonds are considered a safe investment option, there are various risks associated with these bond investments. Let’s take a look –

  • Credit risk: Corporate bonds carry the ‘credit risk’ which means the issuer company may fail to make interest and principal payments on time or may default in making the payment. There are many well-known credit rating agencies that periodically review and estimate the relative risk of default or credit risk based on various information related to the company.
  • Liquidity risk: Unlike stock markets, bond markets do not offer much liquidity due to less frequent trade. Sometimes you may not receive the right price or may not find a buyer to trade your corporate bonds on the secondary market. Hence, corporate bonds involve liquidity risk.
  • Inflation risk: As corporate bonds are fixed-income bearing securities, they are not likely to generate an inflation-beating return over a period of time.
  • Interest rate risk: The price of the corporate bond is inversely related to the interest rate changes in the market. This means, in the rising interest rate scenario the price of the bond is expected to fall and vice versa. Hence, bonds with longer maturity are more sensitive to interest rate changes. Interest rate risk is more for long-term bonds than bonds with shorter maturity periods.

However, you can reduce many of these corporate bond risks by not holding them directly. Mutual funds (corporate bond funds) and exchange-traded funds are the great ways to diversify your risks in corporate bond investments along with earning slightly higher returns. Trading Account

Key Characteristics and Benefits of Corporate Bond Funds

Following are some of the key characteristics and benefits of corporate bond funds –

  • Liquidity: Just like any other debt mutual funds, corporate bond funds allow you to invest and redeem your investments anytime. The main objective of these funds is to provide steady income and reasonable growth to investors. On the other hand, when you invest in corporate bonds directly, either you need to stay invested through the entire bond term or till you find a buyer on the secondary market.
  • Higher return: Corporate bond funds predominantly invest in debt papers issued by companies that include debentures, bonds and commercial papers. The maturity date of each component varies. Corporate bonds offer you a relatively higher returns as it is professionally managed by the fund managers depending on the fund’s objective.
  • Low risk: Risk associated with the corporate bond funds vary depending on the portfolio constituents. If the fund manager chooses to invest in top-rated corporate bonds, the risk would be very low. If the fund manager chooses to invest in slightly low rated bonds, risk associated with the funds would be a little more. One of the important things to remember here is – higher the risk higher is the return. 
  • Price: Depending on the time you buy bonds, the corporate bond price also varies. The price of the bond is linked to interest rate changes in the market. Net asset value (NAV) of the corporate bond fund increases with the increase in the value of corporate bond holdings in the fund’s portfolio.
  • Portfolio exposure and allocation: Corporate bond funds majorly allocate the corpus into corporate bonds. However, a small portion of the corpus is also allocated to sovereign fixed income. Only in case of unavailability of opportunities in the credit space, the fund seeks small exposure into government securities.
  • Tax efficiency: Corporate bonds are quite taxed efficient investment options. Your investments into corporate bond funds for less than three years are subjected to short-term capital gain (STCG) tax as per your income tax slab. Your investments into corporate bond funds for more than three years are subjected to long-term capital gain tax (LTCG) of 20%.
  • Yield to maturity (YTM): It is the internal rate of return that an investor can expect to earn if he holds the bond investments till maturity. The higher the yield to maturity, the higher will be your return on corporate bonds and vice versa.

How to Choose Corporate Bonds?

While investing in bonds, some of the important areas to focus on are the financial conditions of the bond issuer, terms of the bond, the company’s plans to use the proceeds and the significant risks associated with the offer. Likewise, if you are investing in corporate bond funds, focus on components, fund manager’s track record and previous performances of the fund.

In a nutshell, corporate bond investments are an ideal option to add stability to your investment portfolio. Specifically, if you are a risk-averse investor seeking higher returns along with steady income flow, corporate bonds are an ideal investment option. However, it is important to analyse the risk-return profile before you start investing!

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