Corporate bond funds are a type of mutual fund that invests in bonds issued by companies. These bonds are debt instruments that pay a fixed interest rate and return the principal amount at maturity. Corporate bond funds aim to provide regular income and capital appreciation to investors.
In this article we will learn about what are corporate bond mutual funds, how do they work, types of corporate bond mutual funds, and much more.
What is a corporate bond mutual fund?
A corporate bond fund primarily allocates over 80% of its total financial assets to corporate bonds. These bonds are issued by businesses to finance various short-term expenditures, such as working capital requirements, advertising, insurance premium payments, and more.
Corporate bond funds are gaining popularity as a debt instrument among businesses for raising necessary funds, primarily due to their lower associated costs compared to bank loans.
How do corporate bond mutual funds work?
Corporate bond mutual funds work by collecting money from lots of investors and buying a portfolio of highest rated corporate bonds. The fund manager selects the bonds based on various factors such as credit rating, maturity, yield, and risk. The fund earns interest income from the bonds and distributes it to the investors as dividends (this is only for investors under dividend option). The fund also gains or loses value depending on the market price of the bonds.
Types of corporate bond funds
There are different types of corporate bond funds based on the duration and credit quality of the bonds they invest in. Some of the common types are:
- Short-term corporate bond funds: These funds invest in bonds that mature in one to three years. They offer lower risk and lower returns than longer-term funds. They are suitable for investors who want to park their money for a short period and earn steady income.
- Medium-term corporate bond funds: These funds invest in bonds that mature in three to seven years. They offer moderate risk and moderate returns. They are suitable for investors who have a medium-term horizon and want to balance income and growth.
- Long-term corporate bond funds: These funds invest in bonds that mature in more than seven years. They offer higher risk and higher returns than shorter-term funds. They are suitable for investors who have a long-term horizon and want to maximise growth potential.
Also read: Different types of investments
Who should invest in corporate bonds?
Corporate bonds are suitable for investors who want to earn regular income and diversify their portfolio. They offer higher returns than bank deposits and government securities, but lower returns than equity funds. They also carry higher risk than bank deposits and government securities, but lower risk than equity funds. Corporate bonds are affected by interest rate movements, credit risk, liquidity risk, and market risk.
Features and benefits of corporate bond funds
Some of the features and benefits of corporate bond funds are:
- Higher returns: Corporate bond funds offer higher returns than bank deposits and government securities, as they invest in bonds that have a higher interest rate. They can also benefit from capital appreciation if the bond prices rise in the market.
- Liquidity: Corporate bond funds offer liquidity to investors, as they can redeem their units at any time. However, some funds may charge an exit load or a penalty for early withdrawal.
- Low risk: Corporate bond funds offer comparatively low risk as compared to other bond funds as they invest in highest rated securities. However, some bonds may default or delay payments, which can affect the fund’s performance.
- Variety: Corporate bond funds offer variety to investors, as they can choose from different types of funds based on their risk profile, investment horizon, and return expectations. They can also diversify their portfolio across different sectors, industries, and companies.
Risk factors and returns of corporate bond funds
Some of the risk factors and returns of corporate bond funds are:
- Interest rate risk: Corporate bond funds are sensitive to changes in interest rates. When interest rates rise, bond prices fall, and vice versa. This affects the fund’s net asset value (NAV) and returns. Long-term funds are more exposed to interest rate risk than short-term funds.
- Credit risk: Corporate bond funds are exposed to the risk of default or downgrade of the bonds they invest in. If a bond issuer fails to pay interest or principal, or if its credit rating is lowered, the fund’s NAV and returns will suffer. Credit risk funds are more exposed to credit risk than other funds.
- Liquidity risk: Corporate bond funds are subject to the risk of low liquidity or high volatility in the bond market. If the fund manager is unable to buy or sell bonds at the desired price or time, the fund’s NAV and returns will be affected. Liquidity risk is higher for bonds that have a low credit rating, a long maturity, or a low trading volume.
- Market risk: Corporate bond funds are subject to the risk of fluctuations in the bond market due to various factors such as economic conditions, political events, investor sentiment, and global trends. Market risk can affect the fund’s NAV and returns in the short term.
How do corporate bonds make returns?
Corporate bonds make returns in two ways: interest income and capital gains. Interest income is the periodic payment that the bond issuer pays to the bondholder. Capital gains are the difference between the purchase price and the sale price of the bond. Corporate bond funds make returns by earning interest income from the bonds they hold and by selling bonds at a higher price than they bought them.
Taxation rules for corporate bond funds
Corporate bond funds are taxed as debt funds for income tax purposes. The taxation rules for corporate bond funds are:
- Short-term capital gains: Short-term capital gains are the profits made from selling units of the fund within three years of purchase. Short-term capital gains are added to the investor’s income and taxed as per the applicable slab rate.
- Long-term capital gains: Long-term capital gains are the profits made from selling units of the fund after three years of purchase. Long-term capital gains are taxed at 20% with indexation benefit. Indexation is the adjustment of the purchase price of the units based on the inflation rate.
Things to remember before investing in corporate bond funds
Some of the things to remember before investing in corporate bond funds are:
- Know your risk profile: Corporate bond funds have different levels of risk and return. You should choose a fund that matches your risk appetite, investment horizon, and return expectations.
- Check the fund’s performance: Corporate bond funds have different track records of performance. You should check the fund’s past returns, consistency, volatility, and benchmark comparison. You should also look at the fund’s portfolio composition, credit quality, duration, and yield.
- Review the fund’s expenses: Corporate bond funds charge various fees and expenses to manage the fund. You should check the fund’s expense ratio, exit load, exit load, and transaction costs. You should also compare the mutual fund returns with its peers and the category average.
- Diversify your portfolio: Corporate bond funds can help you diversify your portfolio and reduce your overall risk. You should invest in a mix of funds that invest in different types of bonds, sectors, industries, and companies. You should also balance your portfolio with other asset classes such as equity, gold, and real estate.
- Monitor your investments: Corporate bond funds are subject to market fluctuations and require regular monitoring. You should review your investments periodically and make changes as per your goals, risk profile, and market conditions.
Conclusion
In conclusion, corporate bond mutual funds offer investors a compelling avenue to diversify their portfolios and potentially enhance returns. By investing in a diversified pool of corporate bonds, these funds provide exposure to a range of industries and credit qualities, catering to varying risk appetites. Moreover, their relatively lower associated costs compared to individual bond investing make them an attractive option for both individual and institutional investors alike. As businesses continue to rely on corporate bonds to meet their financing needs, corporate bond mutual funds stand as a reliable and accessible vehicle for investors seeking steady income and capital preservation in today's dynamic financial landscape.
