A mutual fund is a terrific investment vehicle that is easily accessible by the masses. This fund is formed by pooling money from investors to invest in different asset classes. It is a popular choice among investors. The fund is professionally managed, well-diversified, easily liquidated, and affordable, particularly for small investors.
Mutual funds can be classified into different categories depending on asset class, investment objectives, structure, and the associated risk and reward. For instance, based on the investment’s primary asset class, mutual funds can be classified into equity schemes, debt schemes, and hybrid schemes. Corporate bond funds, the topic of today’s article, is a category under debt schemes.
In this article, we will talk about what a corporate bond fund is, its types, features & benefits, the risk factors associated with it, and who should invest in it. These form the core of fixed income investments.
Corporate Bond Funds
Businesses issue corporate bonds, also called non-convertible debentures, instead of availing bank loans to meet their fund requirements. Companies prefer debt over equity financing options as debt doesn’t affect the company’s shareholding pattern. Corporate bonds are increasingly becoming popular among businesses within the debt financing option due to the lower associated costs than bank loans.
Corporate Bond Funds are debt mutual fund schemes that primarily invest in corporate bonds. As per the mandate of the Securities and Exchange Board of India (SEBI), a corporate bond fund must invest a minimum of 80% of its total asset value in the highest-rated corporate bonds.
According to the Association of Mutual Funds in India (AMFI), these funds are the third most popular debt funds category in India, after liquid funds and short-duration funds, as of April 2020.
Types of Corporate Bond Funds:
Corporate Bond Funds can be broadly categorized into two different types:
- Funds that invest in corporate bonds issued by top-rated companies, which have incredibly high CRISIL ratings.
- Funds that opt to invest in corporate bonds of companies with a slightly lower credit rating of AA-.
These funds are primarily differentiated by the credit ratings of the companies they invest in. It is, therefore, essential to know the credit ratings for different instruments for different investment tenures.
Credit ratings for long-term debt instruments Credit ratings for short-term debt instruments
|Very high risk
|Expected to default
|Expected to default
Features & Benefits of Corporate Debt Funds
Higher risk-adjusted returns
Corporate Bond Funds generate higher risk-adjusted returns than most other debt instruments in the markets.
Low credit risk
Corporate bond funds must invest a minimum of 80% of their total asset values in top-rated debt instruments, as per the SEBI’s mandate. Since the fund is primarily composed of AAA-rated instruments. This forms a highly safe fund compared to most other debt instruments.
There is a huge demand for corporate bond funds due to their secure nature and high-risk adjusted returns. Therefore, these funds are heavily traded in the secondary markets. Additionally, substantial amounts of short-term liquid securities, typically about 94%, in the fund’s portfolio make it highly liquid.
Suppose investment in Corporate Bond Funds is redeemed within 3 years. In that case, a Short-Term Capital Gain (STCG) tax is charged on the gains, depending upon the investor’s income tax slab.
However, suppose the investment is held beyond 3 years. In that case, the gains are taxed at 20% with indexation under the Long-Term Capital Gains (LTCG) tax. This is a better alternative to investment in Fixed Deposits (FDs), under which gains are taxed per the investor’s income tax slabs.
Risk Factors Associated with Corporate Bond Funds
Although, there is always the possibility of bond issuers defaulting on their obligations. The risk associated with a corporate bond fund is significantly determined by the fund’s portfolio compositions.
Corporate bond funds have significantly lower risk than their debt funds counterparts since they must invest at least 80% of their total asset value in highly-rated (AAA or AA) debt papers issued by companies. But, like all investment instruments, it is subject to market risk. Suppose the economic environment is unfavorable to one of the fund’s constituent companies resulting in credit downgrades by the rating agencies. This can cause a permanent reduction in the fund’s Net Asset Value (NAV) and increase the fund’s default risk.
Few other associated risks are
- Interest rate risk: The risk of the selling price being lower than the purchased price.
- Reinvestment risk occurs after the investor receives the principal amount back but cannot find any instruments that can generate good returns.
- Inflation risk: Rising inflation results in falling bond prices and rising bond yields. This would lead to a reduction in the bond’s market value.
Who Should Invest in Corporate Bond Funds?
Corporate bond funds are for those investors seeking stable returns with low credit risk. They should have a medium risk profile with at least 2 to 3 investment tenures. It is recommended to invest for more than 3 years to benefit from long-term capital gains taxation perks.
Corporate bond funds are an excellent way to diversify your portfolio, particularly if it is too equity-heavy. These will provide stable, fixed returns with a low risk of default. Investing in these funds is preferable to buying individual corporate bonds as it enjoys the highest safety of a diversified fund. They are suitable for 3+ years investment tenures as investors can benefit from gains indexation under Long-Term Capital Gains (LTCG) tax. Also, it should be noted that these funds provide stable higher returns than the G-secs with limited downside risk.
So, investing in corporate bond funds for 2-3 years can be regarded as a safe investment vehicle. However, it should be noted that gains in tenure below 3 years are taxed under the personal income slabs.
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