Corporate Bond Funds

What Are Corporate Bond Funds?

Corporate bonds are debt instruments issued to raise capital by corporates. Also known as Non-Convertible Debentures (NCDs), corporate bonds fund the growth and expansion of corporates. Both public and private companies raise them as an alternative to bank loans.

However, choosing the right bond can be daunting for retail investors who lack sufficient skill and knowledge of the market. In such cases, they can opt for corporate bond funds.

Corporate bond funds are debt fund schemes that invest predominantly in corporate bonds or NCDs. SEBI mandates these funds to invest at least 80% of their corpus in high-rated corporate bonds. Investment in high-quality instruments relatively lowers their credit risk compared to other debt funds schemes.

Who Should Invest in Corporate Bond Funds?

Given the low credit risk, Corporate Bond Funds are suitable for investors with a low-risk appetite. A risk-averse investor aiming for stable returns can go for these funds.

Corporate bond funds returns vary from 7% to 10% if investments are made only in highly rated companies (AAA rated). However, one can also obtain higher returns by targeting slightly low-rated companies, provided the management is in good hands. 

The ideal investment range in corporate bond funds is 3 to 5 years. Hence, investors with at least 2 -3 years of investment tenures should only look at these schemes. However, there is no restriction on the portfolio duration of these schemes.

Some people invest in 4 to 7 years plans for better yields. Prolonged investment also benefits them from long-term capital gain taxation with indexation. This makes the scheme popular among investors in high tax brackets.

However, corporate bond funds returns are also not guaranteed like any other scheme. Hence, there are a few things that investors should consider before investing in the best corporate bond funds:

  • The fund invests in mid to long-term corporate bonds. So investors should look at it as a long-term investment affair.
  • Past year performances do not guarantee future returns. So do not decide based solely on the same. Some market research is essential before investing.
  • Check the expense ratio before choosing a fund—a lower expense ratio results in a higher return.    
  • Some funds charge exit load for an early exit. Remember to factor that in your investment cost.

Features of Corporate Bond Funds

Below are some of the features of corporate bond funds.

Corpus Allocation

A Corporate Bond Fund allocates 80% of its corpus for high-rated corporate bonds. The remaining 20 % is invested in other debts and money market instruments, including REITs. However, managers can also invest in safer government securities to maintain an optimum risk profile.

Bond Price

Bond prices are dynamic and affected by interest rates movements in the market. The prices fall as the interest rate rises and rise as the interest rates fall. This is because of the negative correlation between bond price and interest rates. Comparing the bond’s market price with its par value will give one an understanding of market movements.

Maturity

There is no fixed portfolio duration for corporate bond funds. The optimal duration depends on the future outlook of the market. For example, longer maturity can be beneficial when interest rates are falling. On the other hand, it’s best to keep a lower duration when interest rates are expected to rise.

Taxability of Corporate Bond Funds

The corporate bond funds returns are taxed at the time of receipt of dividends or redemption of the scheme. Dividend income is taxed at the regular slab rate applicable to the investor. Additionally, the mutual fund will deduct a TDS of 10% on dividend income if the total dividend paid to the investor in a year exceeds Rs 5000.

On redemption of the scheme, the investor is taxed as follows:

For Units Sold Within 3 Years

Investors need to pay short-term capital gain tax as per their applicable slab rate.

For Units Sold After 3 Years

Investors can enjoy the benefit of long-term capital gain at 20%. In addition, they also get the indexation benefit which considerably reduces their tax obligation. This makes the best corporate bond funds an excellent alternative to FD and other small saving schemes. FD returns are taxed as per the income tax slab. 

Risk Involved With Corporate Bond Funds

Though the high-rated papers keep corporate bonds comparatively safe on default risk, they are exposed to interest rate and market risks similar to other debt funds. Below is a brief account of the risks corporate bonds are subject to.

Default Risk

Although credit risk is lower in corporate bond funds, there is no guarantee that a company won’t default on its payment. Credit defaults can permanently reduce the fund’s Net Asset Value (NAV). A certain degree of default risk always exists in corporate bond funds. The risk can be mitigated to some extent by investing in high-rated debt funds.

Interest Rate Risk

Corporate bond funds are long-term investment instruments. They are susceptible to interest rate changes in the market. Adverse interest rate movement in the market can reduce their NAV. The interest rate risk is higher in schemes with longer maturities. To compensate for the higher risk, long-duration bond funds also offer higher returns to investors.

Market Risk

All mutual fund schemes are subject to market risk. There is no assurance of capital safety or a guaranteed return. The wrong estimate of fund managers can lead to a loss in investment. It is essential to seek experienced and trusted managers.

Advantage of Corporate Bond Funds     

High on Safety

As 80% of the exposure of corporate bond funds is in top rated debt securities, mostly AAA and AA rated. Hence they carry inherently lower credit risk.

Higher Liquidity

Being high on AAA-rated securities boosts the liquidity of corporate bond funds. Moreover, they are highly traded in the secondary market. Thus a person can easily convert the corporate bond mutual fund into cash when needed. Besides, a considerably large portion of their portfolio is short-term liquid securities. This appropriately insulates the investors from liquidity risks.

Steady Returns

Even during market upheavals, corporate bond funds have proved themselves with steady returns. The performance of corporate bond funds in most periods has topped the performance of banking and PSU debt funds. Their average yield is 7% to 10%, nearly double that government bonds provide.

Tax Benefits

Debt mutual fund schemes offer a considerable tax advantage over traditional investment schemes such as FDs. After allowing indexation benefits, long-term investors (3 years and more) are taxed at only 20%.

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