Corporate Bond Funds : Risks, Returns and Suitability
It is essential to be aware that mutual funds do not invest only in equity as well as debt-related instruments. The investors should select mutual funds that are compatible with their risk profiles. This article will provide information about corporate bond funds, a category of debt fund schemes.
Corporate Bond Debt Funds
All companies can issue corporate bonds, which are also known as non-convertible debt (NCDs). Businesses and companies need capital for their daily activities as well as future expansions and opportunities for growth. For this, they have two options: credit and equity instruments. Debt is a more secure option because it doesn’t impact the shareholders of the company directly. This is why most businesses prefer borrowing from debt instruments in order to raise capital for their operation. It is dependent on the needs of their business. the cost of bank loans is often high for companies. This is why bonds or debentures offer companies an economical alternative to raise funds. Corporate bond securities are the underlying portfolios of credit possibilities for debt funds. When you buy a bond, the company has borrowed money from your. The firm will repay the principal after the maturity time specified on the agreement. In the meantime you will be paid dividend (fixed income) – known as the coupon. In general, coupon payments in India are paid twice per year.
Who is the right person to invest for corporate bonds?
Corporate bonds are a fantastic choice for investors looking to earn higher, fixed income with a risk-free option. Corporate bonds are a safe investment choice when compared with credit funds, as they offer 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 may serve your financial objectives better. Long-term debt funds typically tend to be more risky when interest rates change beyond expectations. Therefore, corporate bond funds make investments in scrips to combat fluctuations. They typically offer an investment period of one year to four years. This can be an added benefit if you remain invested for three or more years. It can also prove to better tax-efficient if belong to the highest income tax slab.
Check out: Online mutual fund portal for investment
Features & benefits of corporate bond funds
The components of bonds issued by corporations
The corporate bond fund invests predominantly in debt securities. They issue debt instruments, which include bonds commercial papers and structured obligations. All of these have an individual risk profile and the maturity date varies.
Price of the bond
Every bond comes with a cost and it’s dynamic. It is possible to purchase the same bond at different rates, according to the time that you’re looking to purchase. Investors should check how it differs from the par value – it will reveal information about the direction of the market.
Par Valuation for the bond
What is this amount that the company (bond issuer) pays you after the bond matures. It’s the principal of the loan. In India the corporate bond’s par value is typically the equivalent of Rs 1,000.
Coupon (interest)
When you buy a bond, the company will pay you interest every month until the time you decide to end the corporate bond or the bond matures. This interest is called the coupon and is a particular percent or par amount.
Current Yield
The annual returns you make by selling the bond is called the current yield. As an example, if coupon rate for the bond that has a Rs. 1,000 par value is 20%, then the issuer has to pay 200 as annual interest.
Yield to maturity (YTM)
The in-house rate is the sum of return for all cash-flows that flow through the bond, the current bond price and the coupon payments up to maturity and the principal. The higher the YTM more, greater your returns and vice versa.
Tax-efficiency
If you are holding an investment in your corporation bond for less 3 years, you will need to be liable for short-term capital gain tax (STCG) determined by the tax slab you are in. On the other hand, Section 112 of the Indian Income Tax mandates 20 percent tax on long-term capital gains. This is applicable to those who hold the bonds for more than three years.
Exposure & allocation
Corporate bond funds, sometimes will take small exposures to government securities too. But they do it only whenever suitable opportunities in the market for credit are available. On average, corporate bond funds will be able to have a 5.22 percentage of allocation to sovereign fixed income.
Risk factors & returns
There’s always a chance that bond issuers will default on their obligations. The risk of defaulting is higher for low-rated securities and goes up exponentially with increasing maturities. If your fund manager invests in highly-rated companies, expect an average yield in the range of 8 to 10%. This is where the risk is very low. On the other hand when you invest in a slightly low-rated but managed well, it may be rewarding. For instance: companies often to offer more attractive coupon rates in order to draw investors. However, there is also a chance an investment manager’s call about a company’s situation is wrong. Therefore, if a business falls behind on its interest payments, principal repayment or the company is further rated downgraded, it’s a setback for investors.
How do corporate bonds make returns?
There is a market for debt that allows for the trading of a variety of bonds. It is a market where prices of bonds vary and can either rise or fall, as they do on the stock market. For instance the mutual fund purchases bonds, and their price then rises. In the end, it could earn more money than what it could have made through interest income by itself. However, it may also go the other way.
Corporate bond funds are of different types.
In general, there are two kinds of corporate bond funds.
- Type one:Type one corporate bonds put money into high-rated businesses – private sector (PSU) banks and other companies.
- Type two:Type two corporate bonds are issued by slightly less rated companies like ‘AA- or below. Let’s look at a straightforward example to better understand this. Let’s say an CRISIL “A” rating bond with 1-year residual maturity is an 0.56 percent chance of default and an CRISIL “A” rated bond with a 3-year residual maturity has a 4.79 percentage chance of defaulting. Typically, corporate bond funds dedicate at least 50% of their portfolio to bonds with AA rank or lower. Thus, there’s always a possibility of one or the other bonds in the portfolio becoming insolvent and causing a decrease of the return on investment.
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