What are Corporate Bond Funds?

Companies need to raise funds to carry out their operations. While many of us aware of the stock markets, corporate bond market is another way to raise funds.   Corporate bonds are securities issued by corporates that have a maturity period of over one year.

The various rating agencies grade corporate bonds based on the creditworthiness of the issuer. AAA rating is the highest rating assigned to any paper. These high quality papers carry the lowest risk to the investor.

Corporate Bond fund is a type of debt fund that invests in highest quality or AAA rated corporate bonds.As per the regulator SEBI’s guidelines, a corporate bond fund has to invest at least 80% of its corpus in AAA-rated papers.

How do corporate bond funds work?

As stated earlier, companies issue corporate bonds to raise funds. Institutional players like mutual funds invest in these papers. The companies pay interest (coupon) to investors over the tenure. After the investment tenure is over, the company return the principal invested by the fund house.

As corporate bond funds invest in many corporate bonds, the increase in the value of a corporate bond may lead to a proportional increase in the fund's value.On the other hand, a fall in the value of a bond may cause loss.

The value of the corporate bond will depend on various factors like capital appreciation of the bonds, interest rates and downgrades of bonds by credit rating agencies, etc.

Things to keep in mind before investing in corporate bond funds

Investment horizon: Corporate bond funds invest in corporate bonds that have medium to long-term maturity period. Hence, it is suitable for investors with an investment horizon of around one to four years.

Rating:  The risk of the fund depends on the papers selected by the fund manager. Typically, AAA rated papers are safer than other papers. Corporate Bond Funds have to invest at least 80% of its portfolio in AAA-rated papers. Hence, it is considered as a safer investment option than other types of funds that invest in AA-rated papers.

Returns: Mutual Fund houses can’t give a fixed rate of return on your investment in corporate bond funds. It will depend on the market conditions and the quality of the bonds held in the fund.   

Diversity:A corporate bond fund invests in several corporate bonds. Funds with less exposure to a single company or group entities are relatively safer than funds with higher allocation to a single group entity.

Default: Although these funds invest in top quality corporate bonds, under certain situations, issuers may not be able to make interest or principal payment on the bonds in due time. This can cause bond default. A large number of defaults can have adverse impact on the fund’s performance and your returns.

Size of the fund: Sticking to a fund with a substantial corpus is less risky than funds with a low corpus. It is because a higher corpus allows for adequate diversification that can lower risk.

Who can invest in corporate bond funds?

Investors with an investment horizon of over 1 year to up to 4 years can invest in corporate bond funds. People looking for an income source can also invest in these funds.

Corporate bond funds are tax efficient than fixed deposits. Investors looking to park their money for over three years in a tax-efficient investment option can also invest in corporate bond funds.

Taxation of the corporate bond funds

Corporate bond fund is a category of debt fund. The taxation of corporate bond funds is akin to other debt funds.

Depending on the investment period, the realised gains are taxed as Short Term Capital Gains(STCG) or Long Term Capital Gains(LTCG).  Tax on Short Term Capital Gains applies if you redeem your mutual funds within three years of investment. The gains are taxed as per your income tax slab. Long Term Capital Gains applies if the units stayed invested for more than three years. For debt funds, LTGC is taxed at 20% along with indexation benefits. Indexation takes into account the increase in inflation from the time of the investment.

Conclusion:

Corporate bond funds invest in high quality AAA-rated corporate bonds. It is a safer debt mutual fund option as it invests 80% of its portfolio in top-rated papers. It is suitable for investors with an investment horizon of nearly three years. It is also a tax-efficient investment option. Consult your mutual fund distributor or financial advisor before investing.