Corporate Bond Funds

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.

Top 5 Corporate Bond Mutual Funds to Invest 2023

Fund Name	Return Since Inception	Epense Ratio
SBI Corporate Bond Fund (G)	6.70%	0.79%
HDFC Corporate Bond fund (G)	8.20%	0.61%
Aditya Birla Sun Life Corporate Bond Fund (G)	9.00%	0.46%
ICICI Prudential Corporate Bond Fund (G)	6.90%	0.58%
Kotak Corporate Bond Standard Plan (G)	7.70%	0.66%

What are Corporate Bond Funds?

Corporate bond 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.

However, the taxation of debt mutual funds has been changed in the Finance Bill 2023. From April 1st 2023, capital gains from debt mutual funds will be taxable as per the investor’s IT slab rate, irrespective of the holding period. Thus, the LTCG benefit for debt mutual funds is no longer available.

Types of Corporate Bond Funds

• 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 Mutual Funds

• Returns: Returns of these 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: These 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. Learn more on mutual fund risks.
• Volatility: They 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. However, from April 1st 2023, capitals gains from debt funds will be taxable as per the investor’s IT slab rate, irrespective of the investment holding period.
• 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 in Corporate Bond Funds

Benefits

• 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. However, from April 1st 2023, capital gains will be taxed as per the investor’s Income tax slab rate.

Limitations

• 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: These 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: It 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.

Conclusion

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