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corporate bond funds
corporate bond funds

Introduction

Corporate bond funds are open ended debt funds that invest at least 80% of their assets in the highest rated corporate bonds. Corporate bond funds use credit opportunities of the corporate debt papers to earn returns. These funds are subject to interest rate risk due to their long durations. Hence making them exposed to market volatility. The underlying securities of corporate bond funds can be both high rated and low rated securities. Therefore, the credit quality for these funds can be low, and they can have significant credit risk.

What are corporate bond funds?

Corporate bond fund schemes are a type of debt securityies. These are the types of bonds that companies’ issue. Corporate bonds are also known as Non-Convertible Debentures (NCDs). Firms or companies raise capital for their operations, growth opportunities and future expansion. They either raise capital through debt or equity. A debt issue will not dilute any shareholding pattern and hence is most preferred by companies. Both public and private companies issue corporate bonds.

Bank loans are not always cheap and can become an expensive affair. Therefore, companies issue debentures or bonds to raise funds which is an economical alternative. Also, sometimes the company pledges its physical assets as collateral.

When one buys corporate bond security, it means that the company is borrowing money from them. Therefore, the company will repay the principal upon maturity. Also, the company pays interest on the borrowing; this is known as the coupon. Mostly, the coupon payments are made twice in a year.

Corporate bond fund category is one of the largest categories within the debt segment (9% of total debt fund’s assets). Corporate bonds are mandated to invest at least 80% of their total assets in the highest rated securities.

Furthermore, corporate bond funds use credit opportunities of the corporate debt papers to earn returns. These funds have longer maturity periods exposing them to interest rate movements and market volatility.

Also, corporate bond funds have a significant credit risk. Companies can default their payments, resulting in a loss for an investor. Often the potential incremental return may not justify the higher credit risk and higher interest rate risk.

The taxation of corporate bond funds is similar to other debt funds. Short term capital gains (investments redeemed within three years) are taxable as per the individual’s income tax slab rate. At the same time, long term capital gains (investments redeemed after three years) are taxable at 20% with indexation benefit.

Types of corporate bond funds

The two broad categories of corporate bond fund schemes are:

Type one: Funds that invest only in debt papers with high ratings. For example, Banks and Public Sector Units (PSU).

Type two: Funds that invest in companies with slightly lower ratings. Debt papers with ‘AA-’ and below ratings.

For example, there are two bonds with different maturities. Bond X is a one-year residual maturity bond with a CRISIL ‘A’ rating and 0.60% chance of default. Bond Y is a three-year residual maturity bond with a CRISIL ‘A’ rating and 5.00% chance of default. Corporate bond funds’ portfolio manager invests the majority of the assets in the highest rated securities. However, there is a significant default risk with the other low rated securities. Therefore, this results in lower portfolio returns.

Features of corporate bond funds

Returns

Returns of corporate bond funds depend on the portfolio of the fund. If the fund’s portfolio invests in high rated bonds and securities, the returns can be lower as the risk in them is lower. However, if the corporate debt fund invests in low rated bonds and securities, the returns can be higher, but the risk tends to be higher too.

Risk

Corporate bond funds invest in corporate debt papers. They tend to have higher maturity and hence are subject to interest rate risks. Furthermore, some debt papers that this mutual fund scheme invests in can be of poor quality, exposing them to credit risk as well.

Volatility

Corporate bond funds are affected by interest rate movements. The volatility will be high when their portfolio has long duration securities and interest rates go up. Investors usually check modified duration apart from returns of the mutual fund scheme before investing in debt funds. The longer the modified duration of a corporate bond fund, the more will be the effect of interest rate changes on it and higher will be the volatility.

Portfolio of a corporate bond

A corporate bond portfolio will have to invest at least 80% of its assets in corporate debt papers like bonds, debentures, commercial papers, and structured obligations. However, a portfolio manager can invest 90% of its assets in corporate debt papers. At the same time, the rest can be allocated to safer investments like government securities to maintain the risk in the portfolio.

Bond prices

The bond prices are affected by movements in interest rates. Bond prices will fall, if the interest rates rise and vice versa. The bond prices also change with the maturity period. Bonds are always issued below par value, and the bond issuer pays back the par value upon maturity. Investors should check how the prices vary from the par value to know the market movements.

Coupon or interest payment

The company issuing the bond pays interest in the form of coupon payment (usually twice a year). It is one way that the corporate bond funds earn returns. The coupon rate is a percentage of the par value.

Taxation

Corporate bond funds are taxed like debt mutual funds. The investments held for less than three years will be taxable at the individual’s income tax slab rates. At the same time, investments with a tenure of more than three years are taxable at 20% with indexation benefits.

Yield to Maturity (YTM)

The annual return on the bond is the yield or return of the bond. The total return of the bond until maturity is called yield to maturity. Higher the yield to maturity (YTM), higher the returns.

Benefits and limitations of investing

Benefits of Corporate Bond Funds

Returns

Corporate bond funds may generate higher returns. The investor is undertaking significant risk when compared to other government bonds. Therefore, the higher the risk, the higher are the returns. Also, the companies make regular coupon payments to their investors.

Tax efficiency

Corporate bonds are suitable for long durations, i.e. for more than three years. Therefore, investing for three years will be an advantage to an investor while filing taxes. These funds are taxable at 20% with indexation benefit. Hence, investors falling under the highest tax bracket may benefit from this the most.

Limitations of Corporate Bond Funds

Default risk

The default risk concerning the company defaulting the payments is quite high. Though the ratings are high, there is no guarantee that a company wouldn’t default its payments. Therefore, corporate bond funds have higher default risk.

Interest rate risk

Corporate bond funds are long term investment options. The interest rates are subject to change. Therefore, changes in interest rates will have an impact on coupon payments. As a result, there will be an impact on the returns.

Volatility

Corporate bond funds can be subject to market volatility. In other words, these long duration investments are subject to fluctuations with the changing interest rates. Bond prices and coupon payments can be affected by dynamic interest rates.

Things to remember before investing

Long term investments

Corporate bond funds invest in corporate bonds and debentures with a medium term to long term tenure. Therefore, they are suitable for long term investors. However, theythere are subject to interest rate risk and default risk.

Knowledge

Investors require some knowledge around corporate bonds while investing in these funds. It might be quite difficult for a common investor to understand the bond market and the potential risks

Returns

Even though the past performance of a corporate debt fund may be good, there is no guarantee for future returns. Moreover, there have been many companies defaulting in the past, and these have an impact on the portfolio returns.

Top funds

It is better to invest in the top corporate bond funds offered by the top asset management companies (AMC). A portfolio investing in high rated securities is considered safer when compared to other low rated securities. However, these funds have their risks, and there is no guarantee in returns.

Who should invest in a corporate bond fund?

Corporate bond funds are suitable for investors seeking fixed and regular income from their investments. The returns from these funds are predictable. However, there is no guarantee of the same. Corporate bond funds do not guarantee returns. Though they are low-risk investments, the returns from them do not justify the risk. The corporate bond funds that do not invest in high rated securities are exposed to credit risk. Additionally, these funds are subject to interest rate fluctuations as they have long modified durations.

Investors seeking low risk investments for low returns can look at investing in corporate bond funds. However, these funds do not guarantee returns. If an investor is willing to invest in these funds, the ideal investment horizon for these funds is 3-5 years.

What are the fund categories under equity funds?

Equity mutual funds are a type of mutual funds that have an asset allocation of at least 65% in stocks. The fund manager of an equity fund can invest using multiple strategies to maximize the portfolio’s return. One can invest in equity funds either through SIP investment or lumpsum investment. SIP investment is a popular investment route for many investors as it reduces the average cost of investment and boosts SIP return. One can check their SIP return of an investment using Scripbox’s SIP calculator. Equity funds have a significant amount of risk associated with it. Hence the returns are higher in comparison to other types of mutual funds. The categories under equity funds are:

  • Large Cap Funds
  • Mid Cap Fund
  • Large and Mid Cap Fund
  • Small Cap Funds
  • Multi Cap Funds
  • Value Funds
  • Thematic / Sector Funds
  • Equity Linked Savings Scheme
  • Focused Funds
  • Dividend Yield Funds
  • Index funds

Apart from equity and debt funds, mutual funds are also categorized as hybrid mutual funds. A hybrid mutual fund invests in both equity and debt instruments. To know more about mutual funds, types and how they work, read our guide.

Conclusion

Corporate bond funds invest in debt papers of companies. This category is one of the largest categories within the Debt Segment (9% of total debt fund assets). Though the funds have predictable returns, they do not guarantee returns. These funds tend to have higher duration exposing them to interest rate movements and market volatility. Since the funds tend to have higher duration, their returns are highly dependent on interest rates. Also, the credit quality of funds in this category is relatively poor.

“Scripbox does not recommend funds in this category. We believe that the potential incremental return is not justified by the higher credit risk and higher interest rate risk.”

Frequently asked questions

What are the other fund categories of debt funds apart from corporate bond mutual funds?

Debt mutual funds are schemes that invest a major portion of the corpus in fixed income or debt instruments. For example, debt mutual funds invest in fixed income instruments such as debentures, government securities, corporate bonds, and money market instruments. Compared to equity mutual funds, debt funds are low-risk investments. The fund manager sets the funds asset allocation is such a way that its portfolio has high-quality instruments. Apart from corporate bond mutual funds, the following are the other categories of debt funds.
1. Liquid Funds
2. Ultra Short Duration Fund
3. Low Duration Fund
4. Money Market Funds
5. Short Duration Funds
6. Medium Duration Funds
7. Medium to Long Duration Funds
8. Long Duration Funds
9. Dynamic Bond Funds
10. Credit risk funds
11. Overnight Funds
12. Banking and PSU Funds
13. Gilt Funds
14. Gilt Fund with 10 year constant duration
15. Floater Funds

Published on September 3, 2020