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Should you invest in corporate bond funds

Oct 10, 2022 / Dwaipayan Bose | 10 Downloaded | 1228 Viewed | |
Should you invest in corporate bond funds
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What are corporate bonds?

Corporate bonds are debt instruments issued by companies to the public. Corporate bonds have a fixed tenure i.e. they mature on a fixed date and they pay regular interest (also known as coupons) at regular intervals e.g. monthly, quarterly or yearly. Corporate bonds can either be secured i.e. backed by the company’s assets or unsecured. Unsecured bonds are more risky than secured bonds. Credit rating agencies assess the risk of corporate bonds and assign ratings to bonds. Different credit ratings and corresponding credit risk profiles are as follows (source: CRISIL, long term scale):-

  • AAA rating – Highest safety

  • AA rating – High safety

  • A – Adequate safety

  • BBB – Moderate safety

  • BB – Moderate risk

  • B – High risk

  • C – Very high risk

  • D – Expected to default

What are corporate bond funds?

Corporate bond funds are debt mutual funds which invest primarily in corporate bonds. As per SEBI’s mandate, corporate bond funds must invest at least 80% of their assets in AAA rated corporate bonds. Since AAA credit rating denotes highest safety, the credit risk in corporate bond funds is low. Credit risk is an important consideration in fixed income investments since a credit default i.e. the issuer failing to make interest or principal payments, can cause a permanent loss. SEBI does not have any duration mandate for corporate funds. Corporate bond fund managers have the flexibility to invest across durations, based on their interest rate outlook.

Yields of corporate bond funds

The tenures of corporate bonds can range from a few months to 20 years. The term structure of interest rates is upward sloping, in other words, yields increase with maturities. At the same time, longer the maturity of a bond, higher is the interest rate risk. Fund managers balance risk and return by investing in bonds of a certain maturity range based on their interest rate outlook. The yields of corporate bond funds are higher than yields of money market and low duration funds, but lower than yields of long duration funds. You should invest according to your risk appetite.

You should know that yields of corporate bonds also depend on their credit ratings. Lower rated bonds give higher returns than higher rated bonds. Since corporate bond funds invest in highest rated bonds, their yields will usually be lower than yields of funds investing in lower rated bonds e.g. credit risk funds. You should understand the credit risks of your debt fund schemes and make informed investment decisions.

Yields are attractive now

We have been in the grip of high inflation globally for more than a year now. From the beginning of this year, central banks around the world e.g. US Federal Reserve and Reserve Bank of India have been increasing interest rates. Recent comments made by the US Federal Reserve Governor indicates that the Fed will increase interest rates more than what the market has been anticipating. The RBI will also be forced to hike rates to protect the Indian Rupee from depreciating. The bond market has discounted future rate hikes in bond yields. Bond yields are now attractive and investors can lock in these yields by holding the bonds till maturity.

The average maturity of corporate bond funds is around 2.4 – 2.5 years (source: Advisorkhoj Research). The yields of 2 and 3 year Government bonds are currently in the range of 7 – 7.3%. Credit spreads of AAA rated bonds are currently around 20 bps (source: CRISIL, as on 31st August 2022). So you can get potential yields of 7.2 – 7.5% (before TER) over next 2 – 3 years by investing in corporate bonds. This is significantly higher than the interest rates of traditional fixed income investments e.g. Bank FDs, Government Small Savings Schemes. If your investment tenure is more than 3 years, you can also get the advantage of long term capital gains taxation. Long term capital gains in debt funds are taxed at 20% after allowing for indexation benefits.

Suggested reading: Should you invest in debt funds when interest rates are rising?

Why invest in corporate bond funds?

  • Corporate bond yields are attractive compared to interest rates of traditional fixed income investments.

  • Low credit risks – high degree of safety, since these funds invest primarily (at least 80% of their assets) in AAA rated corporate bonds.

  • Benefit of long term capital gains taxation for investment tenures exceeding three years.

Who should invest in corporate bond funds?

  • Investors looking for income from their investments.

  • Investors with moderately low to moderate risk appetites.

  • Investors with minimum 2 – 3 years investment horizon – NAVs can be volatile in the short term.

Investors should consult with their financial advisors if corporate bond funds are suitable for their investment needs

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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