Corporate Bonds – Meaning, Type, Risk & Benefits of Investment

Investors who are looking for investment options that offer fixed returns in exchange for their capital opt for Investment Bonds. They may choose from Corporate Bonds, Central Government Bonds, State Government Bonds, and Public Sector Bonds. These investment instruments offer guaranteed returns after a lock-in period with low liquidity. One of the most popular types of fixed return investments is investment bonds.

What are Corporate Bonds?

Corporate bonds are debt securities that companies issue to raise money. Private companies and public corporations issue corporate bonds while promising fixed returns to the investors. These debt instruments act as a loan that borrowers repay after a fixed term and yields interest for the investor. It helps to raise money for a variety of purposes, such as building a new plant or expanding the business.

The company that issues the bond is known as the “issuer”. When you purchase a corporate bond, you lend money to the issuing company. The company promises to return your money, the “principal” amount on a specific maturity date. It also pays you a standard rate of interest until the maturity date. The issuer generally disburses the interest semiannually.

Unlike, equities you do not own a stake or have an ownership interest in the company when you purchase a corporate bond. You get an IOU or an acknowledgment of debt from the company. In simple terms, if you purchase a corporate bond, you are giving the company a loan for its operations. The corporation is thus under a legal contract that binds it to repay the borrowed money. Usually, corporate bonds offer a higher rate of interest in comparison to government bonds.

How Does a Bond work?

A corporate bond works as a fixed income security instrument. Companies raise money from investors by issuing them and in return, they pay an interest known as a coupon. The coupon amount is calculated as a percentage of the face value of the bond. Upon maturity of the bond, the company pays the entire sum back to the investor.

Investors act as lenders and the issuer of the bond becomes the borrower. The company’s ability to repay the loan amount is taken as collateral. Assessment of their ability to repay is done through future revenues or physical assets.

Types of Corporate Bonds

Corporate bonds in India are of the following types:

1. Convertible Bonds: You can exchange these bonds for predefined stocks of the issuing company at your disposal. You can convert these bonds into stocks if you think they are likely to yield better returns than bonds.
2. Non-convertible Bonds: You cannot exchange these bonds with the stocks of the issuer. These bonds remain as purchased till their maturity date.
3. Type One Bonds: These corporate bonds invest in public sector unit (PSU) companies, banks, and other high-rated companies.
4. Type Two Bonds: These corporate bonds invest in companies with low ratings such as ‘AA-‘ and below. These bonds allocate at least half their portfolios to lower-rated companies.  Therefore, they are always at the risk of lower returns due to default.
5. Short Term Maturity Bonds: These bonds have a maturity period of less than one year.
6. Medium Term Maturity Bonds: These bonds have a maturity period between 1 to 5 years.
7. Long Term Maturity Bonds: These bonds have a maturity period of more than 5 years.
8. Fixed-Rate Bonds: These bonds have fixed coupons or an annual rate of interest. It is constant throughout the lifetime of the bond.
9. Floating Rate Bonds: These bonds have a flexible coupon. It is reset periodically as per the benchmark rate.
10. Zero-coupon Bonds: These bonds do not pay any interest. These issuers issue the zero coupon bonds at an upfront discount on their face value.

How are Corporate Bonds Rated?

Before rating corporate bonds, the assessment of a company’s financials is done by credit rating agencies. The rating agencies like CRISIL rate corporate bonds. These ratings range from AAA to Default wherein AAA is the highest rating indicating a low risk of default. AAA corporate bonds are relatively safe and their risk of default is minimal. These bonds are available at lower interest rates in comparison to the bonds with lesser ratings.

How are Corporate Bonds Rated?

Before rating corporate bonds, the assessment of a company’s financials is done by credit rating agencies. The rating agencies like CRISIL rate corporate bonds. These ratings range from AAA to Default wherein AAA is the highest rating indicating a low risk of default. AAA corporate bonds are relatively safe and their risk of default is minimal. These bonds are available at lower interest rates in comparison to the bonds with lesser ratings.

How do Corporate Bonds Work? (Bought and sold)

You can invest in these bonds through a broker who deals with the Retail Debt Market. Alternatively, you can purchase them through mutual funds or exchange-traded funds (ETFs). The maximum investment cap for these bonds is Rs. 2 lakh.

How are Bond Prices, Interest Rates and Yield Related?

Corporate bonds are subject to interest-rate risk or market risk. They tend to rise in value with the fall of interest rates and vice versa. The degree of price volatility is higher with longer. Investors who intend to hold the bond until maturity will not bear the impact of these price fluctuations. They will receive the face value of the bond at maturity. Bond prices and interest rates have an inverse relationship. You can simply understand this as a drop in bond prices when interest rates rise. This happens because new issues with high yields come to market reducing the value of older issues. Similarly, with the decline in interest rates, the bond prices go up. These prices are applicable if the investor sells the bond before maturity.

What are the Risks of Investing in Corporate Bonds?

Corporate bonds are fixed-income debt instruments. According to their working, a company borrows money from investors. In exchange, it pays interest through the bond’s life and principal amount when the bond matures. There is a risk of default of these payments by the company. Additionally, these bonds are prone to interest rate risk.

1. Interest Rate Risk

Corporate bonds are a form of long-term investment in debt securities. During this tenure, the interest rates in the market keep fluctuating. There is a drop in the value of these bonds when interest rates rise. The main reason is the rise in opportunity cost for the investor for holding these bonds. The bond prices fall to compensate for the higher interest rate for the same value of the bond.

The value of the existing bonds falls as investors switch to bonds paying a higher interest rate. Therefore, the investors holding low-value bonds find it difficult to sell their bonds. They may have to bear losses if the value of their bonds goes below the initial purchase price.

2. Credit or Default Risk

Corporate bonds are subject to default risk as credit rating agencies rate them. The bonds with the lowest ratings lure investors with higher interest rates. The credit ratings of corporate bonds help investors identify safer bonds. For instance, bonds with AAA ratings are safe and the risk of default is nearly zero. However, as you move to a lower rating, the risk of default by the company increases. Companies compensate for their lower credit rating bonds by offering a higher interest rate.

Though the ratings give some credibility to the bonds, it does not guarantee anything. Therefore, you must remember that even bonds with a high rating are at risk of defaulting on payments.

3. Liquidity Risk

Unlike the ready market of government bonds, corporate bonds have a thin market. There is a risk an investor may not be able to sell their corporate bonds with few buyers and sellers. If there is a low buying interest it leads to price volatility of that particular bond issue. This adversely impacts a bondholder’s total return upon sale. There is a risk that you may be forced to accept a far lower price than expected upon selling your position.

4. Inflation Risk

Investors purchasing a bond are eligible to receive a rate of return. It may either be fixed or variable depending upon the type of bond. The rate of interest is fixed for the entire duration of the bond or till the time it is held. But in case the cost of living and inflation increase dramatically the purchasing power of the investor reduces. It erodes if inflation rises at a faster rate than income investment. In such a case you may actually achieve a negative rate of return. So, upon factoring in inflation to calculate your true rate of return you will notice a decrease in purchasing power.

Are Corporate Bonds Safer Than Stocks?

Corporate bonds are debt securities issued by public and private corporations to raise money for meeting their business requirements. On the other hand, stocks or shares are equity instruments that give investors ownership security. Issuers commit to paying an interest to those who buy bonds with a promise to repay the invested amount. Thus, bonds generate regular income for investors but companies are not bound to pay a dividend if you invest in stocks. Share prices are prone to market volatility and hence are considered to be riskier than debt securities.
Bonds are a portfolio diversification option but corporate bonds are associated with risks such as credit risk, default risk, and inflation risk. In case the issuer defaults its payments, the investor suffers losses.

Read also about the Bonds vs Stocks

How are Corporate Bonds Taxed?

Corporate bonds are taxed on the basis of long-term as these investment options have a duration of more than three years. Therefore, you get the tax advantage of investing for three years. Hence, it is beneficial for investors falling under the highest tax bracket. The interest you earn on corporate bonds is taxable as per capital gain tax rates. The short-term capital gain tax rate applies if the investment period is less than three years. If it is more than three years, a 20% capital gain tax applies. This is as per section 112 of Income Tax Acts and includes the benefit of indexation.

What are the disadvantages of bonds?

Following are the disadvantages of corporate bonds:

• Risk of losing money
• Interest rate fluctuations
• Lower returns than long term equities

Risk of losing money

Companies issue corporate bonds, and they might default on payments. In case of default, the bond investors will be considered first for payment, and they might get only peanuts. Hence there is always a risk of losing the investment.

Interest rate fluctuations

During interest rate fluctuations, the value of the bond will fluctuate too. If the interest rates rise, the bond might seem unattractive to investors, and the value of the bond will fall drastically. The investor might face a problem selling the bond in the secondary market.

Lower returns than long term equities

Corporate bonds are long term investments, and the returns from them might not match the returns from investing in equities for the same tenure. Equities have the potential to give higher returns in the long term. For the same tenure, these debt securities might not give similar returns.

What are the advantages of corporate bonds?

Following are the advantages of investing in corporate bonds:

• Higher returns
• Tax efficiency
• Liquidity
• Tenure and Coupon structure

Returns

Corporate bond funds may generate higher returns. The investor by investing in them is undertaking significant risk when compared to other government bonds. Therefore, the higher the risk, the higher are the returns. Moreover, these bonds have a higher growth potential than government bonds.  Additionally, the companies also make regular coupon payments to their investors.

Tax efficiency

Corporate bonds are long term investment options with durations for more than three years. Therefore, investing for three years will have a tax advantage. These funds are taxable at 20% with indexation benefit. Hence, investors falling under the highest tax bracket may benefit from this the most.

Liquidity

Most corporate bonds trade on the secondary market. In other words, one can buy and sell these securities even after their issue. Therefore, an investor can sell if the bond prices increase or buy when the prices fall.

Tenure and Coupon Structure

Bonds have different maturities. For example, there are long term, medium term, short term, and perpetual corporate bonds available for investors to choose from. Similarly, bonds have different coupon structures. An investor can choose the coupon structure that best suits them. For example, fixed-rate, floating-rate and zero-coupon bonds.

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