Corporate Bond Funds : Risks, returns and suitability
You need to understand that mutual funds don’t invest exclusively in equity investments but also in debt instruments. Investors should choose only those mutual funds that fit with their risk-response profile. This article provides details about corporate bond funds – which is a group of schemes for debt.
Corporate Bond Debt Funds
Any company can issue corporate bonds, also known as NCFs, also known as (NCDs). Companies or organizations require funds to fund their activities as well as future expansions and growth opportunities. To accomplish this, businesses can use two methods – both equity and debt. The debt option is more secure because it doesn’t directly affect shareholders directly. This is why most businesses prefer borrowing from debt instruments in order to raise capital to fund their business. According to their needs, the cost of bank loans is often high for companies. This is the reason why bonds or debentures can provide businesses with an affordable option to raise funds. Corporate bonds form the foundational portfolios of credit options for debt funds. When you purchase a bond, the firm will borrow money from you. The company will repay it’s principal once it has reached the maturity time period specified on the agreement. While you wait you will get the rate of interest (fixed income) or the coupon. In general, coupons in India occur twice per year.
Who should invest for corporate bonds?
Corporate bonds are a good choice for investors looking for an income that is fixed, but from a safe option. Corporate bonds are considered to be a lower risk alternative to debt funds since they provide capital security. However, these bonds are not entirely safe. If you choose to use Corporate bond funds which invest in top-quality debt instruments, then it will help you achieve your financial goals better. Long-term debt funds typically tend to be more risky when interest rates change beyond expectations. Therefore, corporate bond funds make investments in scrips to reduce fluctuation. They generally have the duration of one calendar year or more to four. This could be an added benefit when you stay invested for up to three years. This could also prove to be more tax efficient if belong to the highest tax bracket for income.
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Benefits and features from corporate bonds
Corporate bonds are composed of components.
Funds for corporate bonds invest predominantly in debt securities. Businesses issue debt documents comprising bonds commercial papers, debentures or structured obligations. All of these components carry an individual risk profile and the date of maturity can be different.
Price of bond
Every bond comes with a price, and it is dynamic. You can purchase the exact bond for different prices in accordance with the date you’re looking to purchase. Investors should be aware of how it varies from the par value it will inform them about the direction of the market.
Par Value for the bond
That is the sum that the business (bond issuer) pays you when the bond matures. It’s the principal of the loan. In India the corporate bond’s par value is usually one thousand rupees.
Coupon (interest)
When you buy bond, the business will pay interest on a regular basis until you exit the corporate bond or until the bond matures. This interest is known as coupon or coupon, which is a set percentage or par amount.
Actual Yield
The annual yield you get from your bond is known as the current yield. As an example, if coupon rate of a bond with Rs 1,000 worth of par is 20 percent, then the issuer has to pay 200 for interest every year.
Yield to Maturity (YTM)
This is the rate in-house of returns of all the bonds’ cash flows including the current bond rate the coupon payments to expiration and the principal. More the YTM, higher will be the returns. The reverse is also true.
Tax-efficiency
If you hold the corporate bond funds for less than three years, you are required to be liable for short-term capital gain tax (STCG) in accordance with your tax bracket. In contrast, Section 112 of the Indian Income Tax mandates 20 percent tax on long-term capital gains. This is applicable to those who hold the bond for more than three years.
Exposure and allocation
Corporate bond funds, often have small exposures to securities issued by government agencies as well. But they do it only when opportunities that are suitable for the credit space are available. In the average corporate bond funds have approximately 5.22 percent of their allotted to sovereign fixed income.
Risk factors & returns
There’s always the possibility of bond issuers failing to meet their obligations. The risk of defaulting is higher in securities that aren’t rated and increases increase exponentially with maturities increasing. If the fund manager you choose to work with invests in highly-rated companies, expect an average return within the range of 8 to 10 percent. In this case, the risk is extremely low. However, if you invest in a lower-rated but well-managed fund then it can be rewarding. In particular, firms tend to offer more attractive coupon rates in order to draw investors. But, there’s possibility for the manager of the fund to judgment for a business that is not performing as expected. So, if a firm defaults on interest payments or principal repayment or is further downgraded, it’s a loss for investors.
How do corporate bonds make returns?
There’s a market for bonds where a range of bonds are traded. This market is where the cost of different bonds can rise or fall, as they do in stock markets. For instance when a mutual fund purchases a bond, and its price increases. Then, it can make more money than what it would have made through interest income on its own. However, it could also be the reverse.
The types of corporate bond funds
Broadlyspeaking, there are two types of corporate bond funds.
- Type One:Type one bonds for corporate purposes invest in high-rated companies – Public sector units (PSU) firms and banks.
- Type Two:Type two corporate bonds put money into slightly lower-rated companies such as ‘AA- and below. Let’s look at a straightforward example for understanding this. Consider the CRISIL “A” graded bond with 1-year residual maturity has an 0.56 percent chance of default and an CRISIL “A” graded bond with a residual of 3 years maturity has an 4.79 percent chance of failing. Typically, corporate bond funds will allocate at least half their portfolios to bonds with AA rank or lower. Therefore, there is always the risk of some or the other bond in the portfolio failing leading to a drop of the portfolio’s returns.
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