What are corporate bonds?

Corporate bonds are financial instruments issued in the market to raise funds from investors.
What are corporate bonds?
3 mins
06 June 2024

Corporate bonds are a form of debt security issued by companies/corporations to raise capital from the public or institutional investors. Investors who buy corporate bonds are lending money to the company issuing the bond. In return, the company makes a legal commitment to pay interest on the principal and, in most cases, to return the principal when the bond comes due, or matures.

When a corporation issues a bond, it essentially borrows money from investors. The bond represents a promise to repay the principal amount, known as the face value or par value, at the bond's maturity date. In the meantime, the company pays periodic interest, typically semi-annually or annually, to bondholders at a predetermined interest rate known as the coupon rate.

Corporate bonds are considered a relatively safer investment compared to stocks because they are backed by the company's assets and cash flows. The creditworthiness of the issuing company is an essential factor to consider when investing in corporate bonds. Credit rating agencies evaluate the financial health and stability of companies and assign ratings to their bonds. The higher the credit rating, the lower the risk associated with the bond, and thus, lower interest rates might be offered.

Types of corporate bonds

Investors have various options when it comes to corporate bonds. Some are short-term bonds with maturities of one to five years, while others are long-term bonds with maturities that can extend to 30 years or more. Additionally, there are different types of corporate bonds, such as:

1. Investment-grade bonds:

These are issued by financially stable and reliable companies with high credit ratings. They typically offer lower interest rates compared to riskier bonds.

2. High-yield bonds (Junk bonds):

Issued by companies with lower credit ratings, high-yield bonds offer higher interest rates to compensate for the increased risk. Investing in these bonds carries a higher possibility of default.

3. Convertible bonds:

These bonds give investors the option to convert their bond holdings into a specific number of the company's common shares at a predetermined conversion ratio. They offer the potential for capital appreciation if the company's stock price rises significantly.

4. Callable bonds:

Some corporate bonds have a callable feature, allowing the issuing company to redeem the bonds before the scheduled maturity date. This feature benefits the company if interest rates decrease after the bond issuance.

5. Zero-coupon bonds:

Unlike traditional bonds that pay periodic interest, zero-coupon bonds do not make regular interest payments. Instead, they are issued at a discount to their face value and grow to reach the face value at maturity, providing investors with a lump sum payment.

Additional read: Stocks vs Bonds

Features of corporate bonds

Corporate bonds have several key benefits and features that make them an attractive investment option for investors:

1. Fixed interest payments:

One of the biggest benefits of corporate bonds is the fixed interest payments that investors receive. This provides a steady stream of income for investors and is especially attractive for those looking for a predictable source of income.

2. Diversification:

Investing in corporate bonds allows for diversification of investments. Instead of investing in individual companies, investors can invest in a portfolio of bonds, reducing the potential risk of any one bond defaulting.

3. Low risk:

Corporate bonds are generally considered a low-risk investment option, as they are backed by the issuing company's creditworthiness and have a lower default risk than high-yield bonds.

4. Principal investment returned:

Once the bond matures, investors receive their principal investment back, thereby minimising the risk of losing money.

5. Higher return compared to traditional fixed-income investments:

Corporate bonds may offer a higher rate of return than traditional fixed-income investments such as savings accounts and term deposits.

6. Flexibility:

Corporate bonds can be sold on the secondary market, providing investors with the flexibility to sell their bonds before the maturity date if they wish to liquidate their investments.

7. Tax benefits:

In some cases, corporate bonds may offer tax benefits to investors. For example, some municipal/public sector undertaking bonds are exempt from federal income tax.

Taxation rules of corporate bond mutual funds

The taxation rules for corporate bond mutual funds depend on their holding timeframe. Here’s a quick break-down to simplify things:

  • If the corporate bond mutual fund is held for less than 3 years, a short-term capital gains tax (STCG) is levied on the investment. STCG is calculated as per the applicable tax slab of the investor.If the corporate bond mutual fund is held for more than 3 years, a long-term capital gains (LTCG) tax is levied on the investment. LTCG is equal to 20% after the indexation benefit is applied.

Difference between corporate bonds, stocks, and government securities

Corporate bonds, stocks, and government securities are distinct investment instruments. Corporate bonds are debt securities issued by companies, providing fixed interest payments and lower risk compared to stocks. Stocks represent ownership in a company and offer the potential for dividends and capital appreciation but come with higher risk. On the other hand, government securities are debt instruments issued by governments, offering fixed income with the lowest risk level due to government backing. Each option appeals to investors based on their risk tolerance and investment objectives.

Additional read: Who can buy bonds

Example

Let us understand this with an example.

To start investing in corporate bonds, investor X approaches the stockbroker and opens a Demat account with them. The account opening process involves providing the necessary documents like identity proof, address proof, and PAN card details.

After opening Demat account, investor X comes across ABC Pharmaceuticals Ltd., a well-established pharmaceutical company in India, offering corporate bonds. The company has a strong track record of financial stability and a credit rating indicating a low risk of default.

ABC Pharmaceuticals Ltd. is issuing bonds with a face value of INR 1,000 each. The bond has a coupon rate of 7% and a maturity period of 5 years. This implies that if investor X invests in one bond, he will receive INR 70 (7% of INR 1,000) as interest income annually for five years.

Impressed by ABC Pharmaceuticals Ltd.'s financial stability and the attractive coupon rate, investor X decides to invest Rs. 1,00,000 in their corporate bonds. With Bajaj Financial Securities Limited, he places an order to buy 100 bonds of ABC Pharmaceuticals Ltd., totalling INR 1,00,000 (100 bonds x INR 1,000 face value).

As he holds the ABC Pharmaceuticals Ltd. bonds, he receives interest payments of RS. 7,000 annually (100 bonds x RS. 70 interest per bond) for the next five years. These interest payments are credited to his bank account, which is mapped with the Demat account. At the end of the 5-year maturity period, he will receive the face value of the bonds, RS. 1,00,000 (100 bonds x RS. 1,000 face value) back.

Conclusion

Corporate bonds are a popular type of debt financing instrument used by public and private corporations to raise funds for their expansion and growth without giving up ownership. Risk-averse investors seeking portfolio diversification and a steady source of income can invest in corporate bonds. While these bonds offer higher yields than conventional fixed-income investments like FDs, they are also riskier. Therefore, investors should thoroughly review the credit rating of the company before investing to balance risk and return.

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Frequently asked questions

Are corporate bond funds safe?

Corporate bond funds are considered safer than equity investments due to their fixed interest payments and diversification of bond investments. However, they still present a risk of default, as with all bond investments.

How much interest do corporate bonds pay?

The interest rate for corporate bonds varies depending on the issuing company and credit rating. Generally, investment-grade bonds pay a lower interest rate than high-yield bonds.

What are the advantages of corporate bonds?

The advantages of corporate bonds include high returns with minimal risk, diversification of bond investments, and fixed interest payments.

What happens when a corporate bond matures?

When a corporate bond matures, investors receive their principal investment back.

Do corporate bonds have tax advantages?

Corporate bonds and its relation with tax advantages shall vary and depend upon the issuer of the bonds.

How are corporate bonds different from term deposits?

Corporate bonds provide a higher rate of return than term deposits, but also carry a higher level of risk. Term deposits provide a fixed interest rate with no risk of default.

What are the 2 types of corporate bonds?

Corporate bonds can be classified into two broad credit classifications: investment-grade and high-yield bonds.  Investment-grade bonds are issued by stable and reliable companies with high credit ratings. High-yield bonds are corporate bonds issued by companies with a lower credit rating. High-yield bonds offer a higher interest rate compared to investment-grade bonds to compensate for their higher risk quotient.

Is corporate bond better than FD?

Choosing between bonds and FDs depends entirely on your risk appetite and investment goals. Corporate bonds have a higher yield potential as compared to FD investments but also entail additional risk. FDs offer relatively lower but guaranteed returns. Therefore, FDs are better suited for risk-averse investors requiring higher liquidity, while corporate bonds are perfect for those with a higher risk profile aiming for higher yields.

Is corporate bond a good investment?

Yes. Corporate bonds make up the second largest section in the global bond market after government bonds. Investors can choose from varying maturity tenures (short or long-term), bond types, credit ratings, and yield potentials to park their funds and earn higher returns than government bonds. Therefore, corporate bonds make for a good and prudent addition to an investor’s portfolio under the category of fixed-income securities.

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