All You Need To Know About Corporate Bonds

A company would need to raise fresh capital for many different reasons like starting a new project, expansion, creating a new product line and many such reasons. However, raising capital is a difficult task. 

Bank loans usually seem like the first and easiest option; however, it can be expensive for the company. So, companies found another way to raise capital.

When taking loans from banks seem like an expensive cost, companies choose to borrow money from its investors and offer them a predetermined interest rate in the form of fixed income throughout a fixed tenure. And this is known as a corporate bond.

In this scenario, both investors and companies get benefits from each other. This is because quite often, it becomes very difficult for an investor to get steady returns on their investment because of market fluctuations. 

Let's take a deeper look into corporate bonds and understand what they offer.

What is a Corporate Bond?

Any company, organization, or firm that wishes to raise capital for expansion or future growth of the company, or for any other purpose, can issue bonds to raise funds. Companies usually have two ways to raise funds: equity or debt instruments. 

A debt instrument is a good way to raise funds as it does not affect the shareholders of the company directly. As debt is a safer way, most companies prefer it to raise capital.

Companies do not prefer taking bank loans as they can be expensive, which is why they choose to offer bonds to investors in order to raise funds.

A corporate bond is thus, a form of debt security which is issued by a company and offered to its investors. Through bonds, the company generates the capital it needs. In exchange, the investor is paid a pre-decided number of interest payments at a fixed or variable interest rate. When the bond expires, or "reaches maturity," the payments are discontinued and later, the original investment is returned.

Features of Corporate Bonds

Below are some of the features of corporate bonds:

Components - Corporate bond funds mainly invest in debt papers that include bonds, commercial papers, debentures, and structured obligations. All of these components of corporate bonds carry their risk profile and maturity periods.

Par Value of the Bond - This is the amount the company pays to the investor when bonds mature and is known as the principal amount of the bond. In India, the par value of the corporate bond is usually Rs. 1,000. By looking at the par value of the bond, investors can also guess the movement of the market.

Price of the Bond - Every bond has a particular price, and an investor may purchase the same bond at a different price depending on the time it was purchased. Mathematically, the price of a bond is equal to the current value of future coupon payments plus the present value of the maturity value, both calculated at the interest rate prevailing in the market.

Coupon (Interest) - When an investor purchases a bond, the company pays regular predetermined interest to the bondholder until the bond matures. The interest offered by the company is known as a coupon.

Current Yield - The annual returns an investor makes from investing in a bond is known as the current yield. Suppose, if the coupon rate of the bond is Rs. 2,000 and the par value is 20%, then the issuer will pay Rs. 400 per year as interest.

Yield to Maturity (YTM) - YTM tells the total return amount received by the investor from holding the bond until it matures. The YTM reflects all the interest payments from the time of purchase of the bond until its maturity period.

Tax-Efficiency - If an investor is holding a bond for three years, they will need to pay short-term capital gains(STCG) based on the tax slab. If the holding period is more than 3 years, then under section 122 of the Indian Income Tax, the investor will have to pay a 20% tax on long-term capital gains(LTCG).

Risk Factors and Returns

There is always a possibility that bond issuers can default on their obligations. Default risk is higher for low rating securities and goes up exponentially with the maturity.  

If the fund manager only invests in high rated companies that offer 8-10% of interest with minimal risk, investors get consistent interest on their investment. On the other hand, if the funds are invested in slightly low-rated companies that manage their funds well, then investors will be rewarded higher interest that comes with higher risks. 

To pool large sums of money and to attract investors, companies also offer higher coupon rates to bondholders; however, there is a possibility that the fund manager of the company is not managing the funds well and is making wrong investment decisions, which can eventually prove to be risky for the company as well the bondholders.

Types of Corporate Bond

There are two types of corporate bond funds. Let's look into them collectively.

Type1: The type 1 bond invests in high credit-rated companies like PSUs (Public Sector Unit) and banks.

Type2: This type of bond invests in slightly low credit rating companies that have a probability of default but offers a higher interest on the investments.

Top Corporate Bond Funds in India

(Data as of October 30th, 2020 : Source: Value Research)

*Disclaimer: This is not an endorsement for any of the above companies

Things to look for before investing in Corporate Bonds

• Corporate bonds invest in corporate debentures and bonds for a longer tenure to earn higher interest. So, corporate bonds should be looked at as a long-term investment.
• Before investing, it is important to first research the market in order to make the right investment choice. Having no prior knowledge of the market can lead to making wrong investment decisions that can affect your financial goals.
• It is better to stick with large AMCs(Asset Management Company), preferably from among the top 5, as it reduces the risk of default. Otherwise, the new investors will stick with the high rated short term debt fund with a lower credit risk.

Who Should Invest in Corporate Bonds?

• Investors seeking to benefit from the highest rated corporate bonds with investment horizons of 1-4 years.
• Those seeking higher returns with lower volatility.
• Investors in the higher income tax slabs seeking greater tax efficiency than fixed deposits for their investment horizons exceeding 3 years.
• Those seeking a higher rate of returns than government bonds, with lower interest rate risk.

Final Thoughts

As an investor, if you are looking for a fixed-income bond with a higher income, then a corporate bond might be a safe option to invest in. This bond is a lower risk investment as it is a debt ensuring capital protection. The tenure of corporate bonds is between the range of 1-4 years. 

However, all corporate bond investments are not safe. If you invest in higher quality debt funds that can serve your financial goals, these funds offer higher interest, but higher returns often come with higher risk. 

Also, risk in corporate bonds can also depend on the portfolio manager's investment patterns.

Companies having higher credit ratings have a lower chance of defaulting while the ones with relatively lower credit ratings have higher risk factors associated with them. 

Hence, as always advised; before making any investment, do your research and invest in those bonds that fulfil your financial goals and suit your financial well being.