What are Corporate Bond Funds & How does it Works?

An Introduction to Corporate Bond Funds

Investing in debt mutual funds can help you achieve your long-term wealth creation goals. Among the multiple types of debt funds to choose from, corporate bond funds are seemingly quite popular. They’re great investment options for diversifying your portfolio and providing a stable source of income. Read on to find out all about corporate bond funds, the different types, how they work and their features and benefits. 

What are Corporate Bond Funds?

Corporate bond funds are a type of debt mutual funds that pool money from multiple investors and use it to invest in bonds issued by companies. These funds typically invest in a diversified portfolio of corporate bonds and are actively managed by experienced professionals called fund managers. 

Generally, most corporate bond funds invest a minimum of 80% of their total assets in high-quality bonds issued by companies. The remaining assets are split across other investments such as government bonds, treasury bills, fixed deposits or equity. The primary objective of a corporate bond fund is to generate steady income for investors at low to moderate risk. 

How Does a Corporate Bond Fund Work?

Now that you’re aware of what corporate bond funds are, let’s look at how it works with the help of a hypothetical example. 

Assume that an AMC launches a new corporate bond fund that invests 90% of its total assets in Indian corporate bonds and the remaining 10% in fixed deposits and government bonds. Let’s say you invest ₹2 lakh in the fund. If the Net Asset Value (NAV) of the fund is ₹200, you would be assigned 1,000 units. 

Now, whenever the companies in the fund’s portfolio pay interest, the AMC distributes it to you in proportion to your holdings. Additionally, the Net Asset Value (NAV) also goes through changes due to market fluctuations over time. For example, if the interest rates in the market fall, the NAV rises. On the other hand, if the interest rates rise, the NAV falls. 

You can redeem your corporate bond fund units at any point in time at the prevailing NAV at a profit or a loss depending on how it has changed since you first invested.

Features and Benefits of Corporate Bond Funds

As an investor, you need to understand the various features and benefits of corporate bond funds before you invest in them. Here’s a quick overview of some of the key advantages and features of this investment option. 

Diversification 

Almost all corporate bond funds invest in a wide range of bonds issued by different companies. Having a diverse portfolio of assets not only gives you a broader exposure but also reduces the risk significantly. 

Liquidity

One of the many advantages of corporate bond funds is that they’re open-ended and highly liquid. This means that you can quickly redeem your investments at the prevailing Net Asset Value at any point in time. 

Stable Income

Companies that issue bonds regularly pay interest to their investors at a particular rate. When you invest in a corporate bond fund, you become eligible for these regular interest payments. In fact, stable and regular income generation is one of the reasons why many investors choose to invest in these funds. 

Capital Appreciation 

In addition to regular income through interest payments, you also get the benefit of capital appreciation. For instance, assume you purchase 1,000 units of a corporate bond fund at an NAV of Rs. 200. A few years later, the NAV of the fund increases to ₹250, at which point you choose to redeem all of your holdings. The returns that you would get would be ₹50,000 (₹50 x 1,000 units). 

Professional Management 

Corporate bond funds are actively managed by highly experienced investment professionals known as fund managers. These individuals are responsible for portfolio selection, rebalancing and other investment-related decisions. They use their experience in the bond market to navigate tough market situations. 

Taxation 

The gains from corporate bond funds, irrespective of whether they’re short-term (holding period of 36 months or lower) or long-term (holding period of more than 36 months), are added to your total income and taxed at the income tax rate applicable to you. 

Types of Corporate Bond Funds

Investors have a range of choices when it comes to choosing the type of corporate bonds based on which funds are formed, including:

• Investment-grade Bonds:

Such bonds are underwritten by companies with robust financial health and superior credit rankings. They are known for offering more modest yields as a trade-off for their lower risk profile.

• High-Interest Bonds (Also known as Junk Bonds):

These are offered by entities with subprime credit scores and, hence, carry a greater likelihood of default. To counterbalance the increased risk, these bonds provide more substantial interest rates.

• Convertible Bonds:

Investors in these bonds hold the flexibility to exchange their bond investment for a set number of the issuer’s common stock shares, contingent on a pre-established conversion rate. This option becomes lucrative if there is a marked increase in the company’s stock price.

• Callable Bonds:

Certain corporate bonds come with a callable option which permits the issuer to pay back the bonds before they reach their stated maturity date. This can be advantageous for the issuer especially if the interest rates fall post-issuance. 

• Zero Coupons Bonds:

These bonds are distinct as they do not provide periodic interest payouts. Instead, they are priced below their nominal value and are designed to reach their full face value upon maturity, resulting in a lump sum for the investor.

Who Should Invest in Corporate Bonds?

Investors Seeking Capital Safety: Corporate bond funds are suitable for those who prioritise the safety of their capital since they are debt instruments that generally provide a stable return and aim to protect the principal amount invested.

Risk-Averse Investors: These funds are ideal for conservative investors who desire better returns than traditional savings but without the high risks associated with equity investments.

Short to Medium-Term Investors: The maturity period of leading corporate bond funds often falls between 1 and 4 years, which is convenient for investors who prefer maintaining access to their funds without compromising liquidity. 

Investors Relying on Professional Management: The risk associated with corporate bonds is influenced by the investment strategies executed by portfolio managers, making these funds a good match for individuals who prefer to rely on professional management to navigate credit risks.

How to Invest in Corporate Bond Funds?

To invest in corporate bond funds through Angel One, follow these steps:

1. Initiate a Demat Account: Sign up for a Demat Account with Angel One, providing necessary documentation like identity and address verification, along with your PAN details.
2. Select a Bond: Look for a reputable company in India issuing corporate bonds. Prefer companies with a solid financial history and low default risk.
3. Purchase Bonds: Decide on the amount to invest. For example, if you buy a bond with a 7% annual coupon rate for a tenure of 5 years, you’ll earn yearly interest on the invested amount.
4. Interest and Maturity: The interest will be directly credited to the bank account linked to your Demat Account. At maturity, you’ll receive the principal amount back.

Remember, the specifics like company name, bond details, and interest rates are hypothetical and will vary according to the actual bonds available for investment through Angel One.

Risk Factors Associated with Investing in Corporate Bond Funds 

Investing in corporate bond funds comes with its own set of risks. Understanding what they are can help you make an informed investment decision. Here’s an overview of three of the most important risk factors you need to be aware of. 

Credit Risk 

Credit risk can be defined as the risk of a company failing to meet its interest payment or repayment obligations. As an investor, you can mitigate this risk to a certain extent by investing in corporate bonds with high credit ratings.  

Reinvestment Risk 

Reinvestment risk can be defined as the risk of reinvesting the proceeds from a corporate bond fund at a rate lower than the original rate. 

Interest Rate Risk 

Interest rate risk can be defined as the risk of a bond fund losing its value due to a change in the interest rates in the market. 

Things to Consider When Investing in Corporate Bond Funds

As an investor, you need to account for the following key factors before investing in corporate bond funds. 

Your Risk Profile 

Although corporate bond funds are comparatively safer than equity, they still carry a few risks. This makes them ideal investment options for investors with a moderate risk profile. 

Credit Quality

The credit quality of the corporate bonds the fund invests in is another key factor you need to consider. Consider investing in funds that feature Indian corporate bonds with high credit ratings. These bonds generally have low risk of default. 

Yield 

Yield can be defined as the annual return, in the form of interest, that you’re likely to receive when you invest in a corporate bond fund. The higher the yield, the more the return on your investment. That said, keep in mind that the corporate bonds’ interest rates may vary depending on their credit quality. 

Expense Ratio 

The expense ratio is a metric that indicates just how much of a fund’s assets are used towards administrative and other expenses. It is expressed as a percentage of your investment value. Investing in funds with a high expense ratio can lower your overall returns. 

Conclusion

Investing in Indian corporate bonds via mutual funds is a good way to diversify your portfolio and gain exposure to the burgeoning debt market. If you’re a moderate-risk investor looking for a stable source of income and a slight chance of capital appreciation, you should consider investing in corporate bond funds. That said, before you invest in such funds, remember to check the credit ratings of the bonds in their portfolio. Also, it is advisable to make an effort to try and understand the bond market and its various risks before investing.   

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