Corporate Bond Funds: Risks, Returns and Suitability
It is essential to be aware that mutual funds don’t invest only in equity additionally, they invest in bonds. Investors should choose only those mutual funds that match with their risk profiles. This article provides details about corporate bond funds, which are a type of debt fund scheme.
Corporate Bond Debt Funds
All companies can issue corporate bonds. They are called Non-Convertible Debentures (NCDs). Businesses or companies require capital to run their day-to-day operations as well as future expansions and growth opportunities. To achieve this, companies have two options: either through equity or debt instruments. Debt is a safer option since it doesn’t impact shareholders directly. Therefore, the majority of companies opt for the issue of debt instruments to raise capital to fund their business. According to their needs, banking loans can be very costly for companies. This is why bonds or debentures offer companies an affordable option to raise funds. Corporate bond securities are the underlying collections of credit opportunities debt funds. When you purchase a bond, the company can borrow funds from you. The company will repay the principal at the end of the maturity time period specified on the agreement. In the meantime, you will receive the interest (fixed income) – known as the coupon. Generally, coupon payments in India are paid twice per year.
Who can invest into corporate bonds?
Corporate bonds are a fantastic choice for investors looking to earn an income that is fixed, but from a secure option. Corporate bonds are a safe investment vehicle when compared to credit funds, as they offer capital security. However, these bonds aren’t entirely secure. If you decide to invest in corporate bond funds that invest in high-quality debt instruments, then it could help meet your financial goals better. Long-term debt funds often tend to be riskier when interest rates change beyond expectations. As a result, corporate bond funds make investments in scrips to reduce the effects of volatility. They typically offer an investment duration of 1 two to three years. This is an additional benefit if you are invested for up to three years. It might also be more tax efficient if have the highest income tax bracket.
Access: Online mutual fund portal for investment
The benefits and features of corporate bond funds
Components of corporate bonds
Corporate bond funds are primarily in debt documents. They issue debt instruments including bonds commercial papers, or structured obligations. All of these have an individual risk profile and the date of maturity varies.
Price of bond
Every bond comes with a cost, and it is dynamic. You can buy the same bond at different rates, depending on the date you’re looking to purchase. Investors must be aware of how the rate varies from the par value – it will give information about the market movement.
Par Valuation for the bond
It is what the firm (bond issuer) will pay you when the bond matures. It’s also known as the principal. In India corporate bonds, the par value is typically at least Rs. 1,000.
Coupon (interest)
When you purchase an obligation, the firm will pay interest on a regular basis until you have to exit the corporate bond or until the bond matures. This is referred to as the coupon that is a specific percent that is the amount of par.
Present Yield
The annual returns you make from the bond is called”current yield”. For example, if coupon rate for the bond that has a Rs. 1,000 worth of par is 20 percent, then the issuer is paying Rs 200 for interest every year.
Yield to Maturity (YTM)
This is the rate in-house of return for all cash-flows from the bond as well as the current bond price and the coupon payments up to completion and the principal. Greater the YTM greater the YTM, the higher your returns , and vice versa.
Tax-efficiency
If you hold any corporate bonds that are less than 3 years, then you must make payments for capital gains taxes on short-term investments (STCG) depending on your tax slab. On the other hand, Section 112 of the Indian Income Tax mandates 20% tax on long-term capital gains. This applies to people who have the bond for more than three years.
Exposure & allocation
Corporate bond funds, at times are able to take small exposures to government securities , too. However, they do so only when opportunities that are suitable for the credit space are offered. On average, corporate bond funds will comprise approximately 5.22 percentage of allotted to fixed income of sovereigns.
Risk factors & returns
There’s always the risk of bond issuers failing to meet their obligations. This risk of default is more pronounced in securities that aren’t rated and increases in a spiral upwards with the maturities of increasing. If your fund manager invests only in highly rated companies, expect an average return within the range of 8%-10%. In this case, the risk is as low. However investing in a somewhat low-rated however, a well-managed and managed fund it could be profitable. For instance, some companies prefer to give somewhat higher coupon rates to attract investors. But, there’s possibility there is a chance that fund managers call on a company that isn’t performing well. So, if a firm has a financial problem with interest payments or principal repayment or the company gets downgraded further, then it’s a loss for investors.
How do corporate bonds make returns?
There’s a market for bonds in which a variety of bonds are traded. On this marketplace, the prices of bonds vary and can either rise or fall, as they do in the markets for stocks. For example the mutual fund purchase an obligation, and its price increases. Then, it can make more money than the amount it could have earned by generating interest alone. But, it can also reverse the process.
Funds for corporate bonds of various types
The general rule is that there are two types of corporate bond funds.
- Type one:Type one corporate bond invest in highly rated companies – the public sector unit (PSU) businesses and banks.
- Type two:Type Two corporate bonds invest in slightly lower rated companies such as ‘AA- or below. Let’s look at a straightforward example to understand this. Consider the CRISIL “A” graded bond with 1-year residual maturity is a 0.56 percent chance of default and an CRISIL “A” rated bond with a residual of 3 years maturity has an 4.79 percentage chance of defaulting. Most corporate bond funds are able to allocate at least half of their portfolio to bonds that have AA ranks or lower. Thus, there’s always a chance of one or the other bonds in the portfolio becoming insolvent, resulting in the drag-down of returns to the portfolio.
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