What are corporate bond funds?

Corporate bond funds are a type of debt fund that primarily invests in bonds issued by private companies with an AA+ and above credit rating. Imagine these bonds as loan agreements or IOUs, with companies borrowing money from investors (like you and me) and agreeing to repay the principal amount along with interest over a set period. By pooling our money with other investors, these funds offer access to a diversified portfolio of corporate bonds, spreading out the risk and optimising the return potential.

• Table of contents

• What is a corporate bond mutual fund?
• How do corporate bond mutual funds work?
• Types of corporate bond funds
• Who should invest in corporate bonds?
• Features and benefits of corporate bond funds
• Risk factors and returns of corporate bond funds
• Taxation rules for corporate bond funds

What is a corporate bond mutual fund?

A corporate bond mutual fund is a type of debt mutual fund that primarily invests in bonds issued by private companies. These bonds represent loans provided by investors to corporations, with a commitment to periodic interest payments and the eventual return of the principal amount.

How do corporate bond mutual funds work?

1. Pooling of funds: Investors contribute money, which is collectively managed in the fund.
2. Diversification: The fund manager allocates investments across corporate bonds from various companies in different industries.
3. Professional management: A fund manager oversees the portfolio, selecting bonds based on factors like credit quality, interest rates, and market trends.
4. Interest income: Periodic interest payments are received from the bond issuer.
5. NAV movement: The fund’s value may rise if the market price of the underlying bonds increases.

Also Read: What Are Corporate Bonds and How Are They Bought And Sold?

Types of corporate bond funds

Corporate bond funds typically invest in companies with high credit ratings. This could include top public sector companies or private enterprises with a credit rating of AA+ and above.

Within this, fund managers can choose the portfolio composition based on various parameters. They may choose to invest in short-duration, medium-duration or long-duration bonds or a combination of these, to balance risk and return potential.

While corporate bond funds are subject to interest rate risk and the risk of default, the high credit quality of the underlying bonds can mitigate default risk. Meanwhile, the interest rate risk will depend on the maturity profile of underlying securities in the portfolio. Usually, bond prices are inversely proportional to interest rates. When interest rates rise, the value of bonds falls and vice versa. Bonds with a longer maturity tend to be more sensitive to interest rate changes.

Who should invest in corporate bonds?

Corporate bond mutual funds can be suitable for investors who:

• Seek moderate risk: These funds usually carry lower risk than equity funds but higher risk than government bond funds.
• Seek potential regular income: They provide periodic interest payments which can result in potential for income if investors seek IDCW payouts.
• Seek diversification: Investing in a portfolio of corporate bonds can help reduce the risks associated with holding individual bonds.

Features and benefits of corporate bond funds

Having understood the corporate bond funds meaning, let's see why one may consider investing in such funds. Here are the benefits of such funds:

• Relatively steady income potential: Corporate bonds generate regular interest payments, providing a potentially reliable source of income for those nearing retirement or seeking to supplement their current earnings.
• Relatively low volatility: While not risk-free, corporate bond funds tend to be less volatile than equity funds, making them suitable for investors who prioritise less volatility over high-octane growth.
• Diversification: By investing in a range of corporate bonds, these funds provide investors with diversification benefits, reducing the impact from any individual issuer.
• Regular inflow of funds: Investors in corporate bond funds tend to receive regular Income distribution cum capital withdrawal (IDCW), offering a steady income inflow of funds. This makes them suitable for those looking for a reliable source of cash flow.
• Professional management: Fund managers employ their expertise to actively manage the portfolio, making dynamic decisions based on market conditions and credit quality assessments.

Risk factors and returns of corporate bond funds

Corporate bond funds, while having the potential to provide relatively steady returns, come with certain risks:

• Credit risk: This refers to the possibility that a bond issuer may fail to meet its debt obligations. Bonds with lower credit ratings generally offer higher yields but also carry greater risk.
• Interest rate risk: Bond prices typically move in the opposite direction of interest rates. When rates rise, bond values may decline, and vice versa. Funds holding longer-duration bonds tend to be more affected by interest rate fluctuations.
• Liquidity risk: Some corporate bonds, especially those from smaller issuers, may have lower liquidity, making it harder to sell units quickly. Market conditions can also impact how easily a fund’s holdings can be traded.
• Market risk: Economic slowdowns, shifts in investor sentiment, and other external factors can influence bond prices.

Taxation rules for corporate bond funds

Since April 2023, gains from all debt funds including corporate bond funds are taxed at the investor’s applicable income tax slab rate, regardless of the holding period. This means both short-term and long-term capital gains are now taxed as per the slab rate.

Also Read: Understanding the debt market: A comprehensive guide for investors

Conclusion

Corporate bond funds are an invaluable option for investors seeking a blend of steady income (IDCW), moderate growth potential, and relative stability of capital. Remember, thorough research, careful consideration, and professional guidance are essential when venturing into the realm of corporate bond funds.

FAQs

How do corporate bond mutual funds work?

Corporate bond mutual funds invest in debt instruments issued by corporations. Fund managers select bonds based on their credit ratings and coupon rates. Potential returns are generated primarily through interest payments. The fund’s performance depends on the issuers' creditworthiness and the prevailing interest rates in the economy.

What are the different types of corporate bond funds?

Corporate bond funds by themselves are a type of debt mutual fund and do not have sub-types. However, other debt funds may also invest in corporate bonds along with government securities.

How to invest in corporate bond mutual funds?

Investors can invest directly through fund houses or via distributors. Investments can be made through a lump sum or SIP.

How to select the right corporate bond mutual fund?

Assess the credit quality and portfolio composition of the fund. Consider the fund house’s reputation and review the fund manager’s track record and past performance*. Be sure that the fund aligns with your goals, investment horizon and risk apptite.
*Past performance may or may not be sustained in future.

Are corporate bond mutual funds risky?

Yes, corporate bond funds are subject to credit and interest rate risks. Bonds with lower ratings carry higher credit risk, while longer-duration bonds are more affected by interest rate fluctuations. The overall risk depends on the composition of the fund’s holdings.

Is it advisable to invest in corporate bond funds?

Corporate bond funds can be beneficial for those looking for the potential for relatively steady returns and portfolio diversification. Their suitability depends on individual risk tolerance and investment objectives. They may help balance equity exposure in a diversified investment strategy.

What risks are associated with corporate bond funds?

These funds face credit risk (risk of issuer default), interest rate risk (price changes due to fluctuating interest rates), and liquidity risk (difficulty in selling bonds). Lower-rated bonds generally carry greater credit risk.

How are corporate bond funds taxed?

Returns from corporate bond funds are taxed as per the investor’s income tax slab. Indexation benefits no longer apply. The returns are added to taxable income and are taxed according to the investor’s applicable slab rate.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.