Corporate Bond Funds : Risks, Returns and Suitability
It is important to know that mutual funds do not invest in only equities, however they also invest in loans. Investors must select only mutual funds that fit with their risk-response profile. This article gives information about corporate bond funds – a class of debt fund schemes.
Corporate Bond Debt Funds
Every company is able to issue corporate bonds, also called Non-Convertible Debentures (NCDs). Companies or organizations require capital to run their day-to-day activities as well as future expansions and growth opportunities. To achieve this, companies have two options – debt and equity instruments. Debt is a more secure option because it doesn’t directly affect shareholders directly. Thus, many companies favor using debt instruments to raise capital for their operations. According to their needs, the cost of bank loans is often high for businesses. This is why bonds or debentures offer companies an economical option to raise funds. Corporate bond securities form the base collections of credit opportunities debt funds. When you buy bonds, the business takes money on loan from you. The firm will repay it’s principal once it has reached the maturity period stipulated on the agreement. While you wait, you will receive the payment of the interest (fixed income) called the coupon. Typically, coupon payments in India occur twice per year.
Who is the best person to invest for corporate bonds?
Corporate bonds are a fantastic choice for investors looking for a fixed but higher income from a secure investment. Corporate bonds are an extremely low risk alternative to debt funds because they offer capital security. However, they aren’t completely safe. If you select corporate bond funds that invest in top-quality debt instruments, then it can serve your financial objectives better. Debt funds that are long-term tend to be riskier when interest rates rise above expectations. This is why corporate bond funds make investments in scrips to fight volatility. They usually go for the duration of one two to three years. This is an additional benefit if you remain invested for three or more years. It might also better tax-efficient if have the highest tax bracket for income.
Benefits and features that come with corporate bond funds
Parts that make up corporate bond
Corporate bonds are predominantly in debt securities. Companies issue debt paper comprising bonds, debentures, commercial papers or structured obligations. All of these have an individual risk profile and the maturity date also differs.
Price of bond
Each bond has a cost and it’s a variable. You can buy the same bond for different prices in accordance with the date you’re looking to purchase. Investors should check how it differs from the par value , as it will inform them about the direction of the market.
Par The value of the bond
What is this amount the organization (bond issuer) pays you when the bond matures. It is the loan principal. In India, a corporate bond’s par value is usually Rs 1,000.
When you buy bond, the business will payout interest regularly until you exit the corporate bond or until the bond matures. This is referred to as the coupon of a certain percent of the par value.
The annual yield you get from the bond are referred to”the current yield. For example, if coupon rate for one bond of Rs.1,000 per cent, the issuer is paying Rs 200 as the interest per year.
Yield To Maturity (YTM)
This is the rate in-house of return for all cash-flows that flow through the bond including the current bond rate and coupon payments, up to maturity and the principal. The higher the YTM, higher will be your returns and vice versa.
If you hold your corporate bond fund for less than three years, you are required to pay short-term capital gains tax (STCG) depending on your tax bracket. However, Section 112 of the Indian Income Tax mandates 20% tax on long-term capital gains. This applies to those who have the bond for more than three years.
Exposure & allocation
Corporate bond funds, sometimes, do take small exposures to securities issued by government agencies as well. But they do so only when there are no opportunities suitable in the credit space are available. On average corporate bond funds be able to have a 5.22 percentage of allocation to fixed income of sovereigns.
Risk factors & returns
There is always the chance of bond issuers failing to meet their obligations. This default risk is higher for securities with lower ratings, and will go to an exponential rate with increasing maturities. If your fund manager invests in highly rated companies, expect an average return of range of 8%-10%. In this case, the risk is also minimal. On the other hand, if you invest in a low-rated, but managed well, you could reap the rewards. For instance, many companies are known to offer slightly higher coupon rates to attract investors. But, there’s possibility for the manager of the fund to choice regarding a company’s performance is not the best. Therefore, if a business defaults on interest payments or principal repayment , or is downgraded even more, it’s a blow to investors.
How do corporate bonds make returns?
There is a debt market where several bonds are traded. This market is where the price of various bonds can increase or fall, as they do in the stock market. For instance when a mutual fund purchases a bond, and its price rises. In the end, it could earn an additional amount of money above and beyond what it would have made from the interest earnings on its own. But, it might also turn around.
Funds for corporate bonds of various types
The general rule is that there are two kinds of corporate bond funds.
- Type One:Type one corporate bond are issued to high-rated companies, private sector (PSU) firms and banks.
- Typ TwoType Two corporate bonds have a lower rating and are used to invest in companies like ‘AA-‘ and below. Let’s look at a straightforward example to help us understand this. Suppose, you have a CRISIL “A” rating bond that has a one-year residual maturity has an 0.56 percent chance of default and a CRISIL “A” rating bond that has a 3-year residual maturity has a 4.79% chance of defaulting. Most corporate bond funds will allocate at least half of their portfolio to bonds that have AA ranks or lower. This means that there’s always the risk of some or the other bond in the portfolio defaulting which could result in a reduction of returns to the portfolio.
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