A corporate bond fund is a mutual fund that primarily invests in corporate bonds, allocating over 80% of its assets to these securities. Corporations issue corporate bonds to finance various operational expenses, including working capital, marketing initiatives, and insurance premiums.
Corporate bond funds have gained traction as a cost-effective financing option for businesses compared to traditional bank loans.
What are Corporate Bonds?
Corporate or company bonds are financial instruments issued by companies to raise capital from investors. When investors buy these bonds, they are essentially lending money to the company. In return, the company agrees to pay interest and repay the principal amount when the bond matures.
When a corporation issues a bond, it essentially borrows money from investors. The bond represents a promise to repay the principal amount, known as the face value or par value, at the bond's maturity date. In the meantime, the company pays periodic interest, typically semi-annually or annually, to bondholders at a predetermined interest rate known as the coupon rate.
Corporate bonds are considered a relatively safer investment compared to stocks because they are backed by the company's assets and cash flows. The creditworthiness of the issuing company is an essential factor to consider when investing in corporate bonds. Credit rating agencies evaluate the financial health and stability of companies and assign ratings to their bonds. The higher the credit rating, the lower the risk associated with the bond, and thus, lower interest rates might be offered.
Types of corporate bonds
Investors have various options when it comes to corporate bonds. Some are short-term bonds with maturities of one to five years, while others are long-term bonds with maturities that can extend to 30 years or more. Additionally, there are different types of corporate bonds, such as:
1. Investment-grade bonds
Corporate bonds are categorised based on their creditworthiness, as determined by credit rating agencies. Investment-grade bonds, rated BBB- or higher up to AAA, are issued by financially stable corporations and are generally considered to have a low risk of default on interest and principal payments.
2. High-yield bonds (Junk bonds)
High-yield bonds, commonly referred to as junk bonds, are debt securities issued by corporations perceived to have a higher risk of default compared to investment-grade bonds. Due to the issuer's potential financial instability, there is increased uncertainty regarding the timely payment of interest and principal upon maturity. These bonds typically offer higher interest rates to compensate investors for the elevated credit risk associated with such issuances..
3. Convertible bonds
These bonds give investors the option to convert their bond holdings into a specific number of the company's common shares at a predetermined conversion ratio. They offer the potential for capital appreciation if the company's stock price rises significantly.
4. Callable bonds
Some corporate bonds have a callable feature, allowing the issuing company to redeem the bonds before the scheduled maturity date. This feature benefits the company if interest rates decrease after the bond issuance.
5. Zero-coupon bonds
Unlike traditional bonds that pay periodic interest, zero-coupon bonds do not make regular interest payments. Instead, they are issued at a discount to their face value and grow to reach the face value at maturity, providing investors with a lump sum payment.
Additional read: Stocks vs Bonds
Features of corporate bonds
Corporate bonds have several key benefits and features that make them an attractive investment option for investors:
1. Fixed interest payments
One of the biggest benefits of corporate bonds is the fixed interest payments that investors receive. This provides a steady stream of income for investors and is especially attractive for those looking for a predictable source of income.
2. Diversification
Investing in corporate bonds allows for diversification of investments. Instead of investing in individual companies, investors can invest in a portfolio of bonds, reducing the potential risk of any one bond defaulting.
3. Low risk
Corporate bonds are generally considered a low-risk investment option, as they are backed by the issuing company's creditworthiness and have a lower default risk than high-yield bonds.
4. Principal investment returned
Once the bond matures, investors receive their principal investment back, thereby minimising the risk of losing money.
5. Higher return compared to traditional fixed-income investments
Corporate bonds may offer a higher rate of return than traditional fixed-income investments such as savings accounts and term deposits.
6. Flexibility
Corporate bonds can be sold on the secondary market, providing investors with the flexibility to sell their bonds before the maturity date if they wish to liquidate their investments.
7. Tax benefits
In some cases, corporate bonds may offer tax benefits to investors. For example, some municipal/public sector undertaking bonds are exempt from federal income tax.
Why corporations sell bonds?
Corporate bonds are a fundamental instrument for businesses seeking to raise capital. They represent a form of debt financing, providing a viable alternative to equity financing. By issuing bonds, corporations can obtain necessary funds without relinquishing ownership or control. Debt financing often offers advantages over equity financing, primarily due to its lower cost structure. This makes it an attractive option for companies seeking to fund specific projects or enhance their overall financial position.
A corporation's creditworthiness plays a pivotal role in determining the terms of its bond issuance. Companies with consistent earnings potential and a strong financial profile can typically secure bonds at more favourable interest rates. In situations where short-term capital is required, corporations may opt to issue commercial paper. This instrument shares similarities with bonds but typically matures within a shorter timeframe.
How corporate bonds are sold ?
Corporate bonds are typically issued in denominations of Rs. 1,000 and feature a standardized coupon payment structure. To facilitate the sale of bonds, corporations often engage investment banks to underwrite and market the offering to investors.
Investors who purchase corporate bonds receive regular interest payments from the issuer until the bond's maturity. At maturity, investors are entitled to receive the face value of the bond. The interest rate on corporate bonds can be fixed or variable, depending on the underlying economic indicator.
To provide flexibility, corporate bonds may include call provisions, allowing the issuer to redeem the bonds early under certain conditions, such as a significant decline in interest rates.
Investors also have the option to sell their corporate bonds before maturity. The selling price of a bond is influenced by factors such as the time remaining until maturity and prevailing market conditions.
For investors seeking exposure to corporate bonds without the need for individual security selection, bond mutual funds and ETFs offer convenient and diversified investment options.
Taxation rules of corporate bond mutual funds
The taxation rules for corporate bond mutual funds depend on their holding timeframe. Here’s a quick break-down to simplify things:
- If the corporate bond mutual fund is held for less than 3 years, a short-term capital gains tax (STCG) is levied on the investment. STCG is calculated as per the applicable tax slab of the investor.
- If the corporate bond mutual fund is held for more than 3 years, a long-term capital gains (LTCG) tax is levied on the investment. LTCG is equal to 20% after the indexation benefit is applied.
Difference between corporate bonds, stocks, and government securities
Corporate bonds, stocks, and government securities are distinct investment instruments. Corporate bonds are debt securities issued by companies, providing fixed interest payments and lower risk compared to stocks. Stocks represent ownership in a company and offer the potential for dividends and capital appreciation but come with higher risk. On the other hand, government securities are debt instruments issued by governments, offering fixed income with the lowest risk level due to government backing. Each option appeals to investors based on their risk tolerance and investment objectives.
Additional read: Who can buy bonds
Example
Let us understand this with an example.
To start investing in corporate bonds, investor X approaches the stockbroker and opens a Demat account with them. The account opening process involves providing the necessary documents like identity proof, address proof, and PAN card details.
After opening Demat account, investor X comes across ABC Pharmaceuticals Ltd., a well-established pharmaceutical company in India, offering company bonds. The company has a strong track record of financial stability and a credit rating indicating a low risk of default.
ABC Pharmaceuticals Ltd. is issuing bonds with a face value of Rs. 1,000 each. The bond has a coupon rate of 7% and a maturity period of 5 years. This implies that if investor X invests in one bond, he will receive Rs. 70 (7% of Rs. 1,000) as interest income annually for five years.
Impressed by ABC Pharmaceuticals Ltd.'s financial stability and the attractive coupon rate, investor X decides to invest Rs. 1,00,000 in their corporate bonds. With Bajaj Financial Securities Limited, he places an order to buy 100 bonds of ABC Pharmaceuticals Ltd., totalling Rs. 1,00,000 (100 bonds x Rs. 1,000 face value).
As he holds the ABC Pharmaceuticals Ltd. bonds, he receives interest payments of Rs. 7,000 annually (100 bonds x Rs.70 interest per bond) for the next five years. These interest payments are credited to his bank account, which is mapped with the Demat account. At the end of the 5-year maturity period, he will receive the face value of the bonds, Rs. 1,00,000 (100 bonds x Rs. 1,000 face value) back.
Conclusion
Corporate bonds are a popular type of debt financing instrument used by public and private corporations to raise funds for their expansion and growth without giving up ownership. Risk-averse investors seeking portfolio diversification and a steady source of income can invest in company bonds. While these bonds offer higher yields than conventional fixed-income investments like FDs, they are also riskier. Therefore, investors should thoroughly review the credit rating of the company before investing to balance risk and return.
