Corporate Bond Funds

Before discussing corporate bond funds, let’s discuss the building blocks of these funds - corporate bonds. Corporate bonds are debt securities issued by corporations to raise capital for various purposes, such as working capital, capital expenditure or refinancing existing debt etc.

Individuals and institutional investors who purchase corporate bonds lend money to the company for a specified period of time and receive periodic interest payments. The company repays the bond’s face value when the bond matures.

Corporate bond funds are open-ended debt mutual fund schemes that invest in a diversified portfolio of corporate bonds with the mandate of minimum investment of 80% of its amount/corpus in corporate bonds rated AA+ and above.

As of February 29, 2024, this fund category has assets under management (AUM) of Rs 1,46,747.48 crore with 21 schemes with the oldest being more than 27 years old, and the category ranked 3rd in the list of open-ended debt funds according to the Association of Mutual Funds in India (AMFI).

Source: AMFI website as of February 29, 2024

While you should identify your risk profile and plan your financial goals before investing in corporate bond funds, here are some situations where they may fit in:

Alternative to Bank Fixed Deposits

As of February 19, 2024, the annual return for corporate bond funds is close to 8%. On the other hand, fixed interest rates offered by large banks range between 6.6-7.1%. So corporate bonds funds have the potential to generate higher returns than fixed deposits.

Source: Valueresearch, SBI, HDFC Bank, ICICI Bank, BOB websites as of February 19, 2024

Note: While the corporate bond funds are good alternatives to bank fixed deposits, they are not insured like bank fixed deposits. Up to Rs. 5 lakh per bank account are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Portfolio Diversification

Investors looking to diversify their portfolios beyond equities may include corporate bond funds to spread risk. Investors with a lower risk tolerance who are uncomfortable with the volatility associated with stocks may find corporate bond funds more in line with their risk preferences.

Both the corporate bond funds and bank FDs look similar but have subtle differences as stated below.

Dividend Taxation

These funds pay out dividends when you invest in their IDCW (Income Distribution Cum Withdrawal) option. Dividends are taxed at your marginal income tax rate, and TDS (Tax Deducted at Source) at 10% applies to dividends received more than Rs 5,000 per AMC per financial year.

Steady Income

Corporate bond funds primarily invest in bonds that pay interest periodically. This feature makes them suitable for income-seeking investors who want a predictable income stream using the IDCW option.

Professional Management

These funds are managed by experienced fund managers who analyze market conditions, interest rate movements, and credit risks. Their expertise helps in making informed investment decisions to optimize returns. For example, HDFC corporate bond fund is managed by Anupam Joshi that has 14 years of experience in fund management (As of 18 Apr 2024)

Diversification

Corporate bond funds invest in a diversified portfolio of bonds issued by different companies and industries. This diversification helps spread risk and reduces the impact of poor performance from any single issuer. For example, ICICI Prudential corporate bond fund has invested in more than 120+ companies’ bonds to diversify its investments (As of 18 Apr 2024).

Lower Volatility

Compared to equity mutual funds, corporate bond funds tend to have lower volatility. They are generally less sensitive to market fluctuations, making them suitable for investors with a lower risk tolerance.

Accessibility for Retail Investors

Corporate bond funds make it easier for individual investors to access the bond market, which may require a larger investment if buying individual bonds, whereas users can start investing in these funds with as low as Rs 100. This accessibility is beneficial for retail investors.

Interest Rate Risk

Corporate bond funds are sensitive to changes in interest rates. When interest rates rise, the value of existing bonds in the fund may decline.

Credit Risk

There is a risk of default by the issuers of corporate bonds held in the mutual fund. Even though fund managers aim to select bonds with higher credit ratings, unexpected financial difficulties of the issuing companies can impact the company’s ability to pay principal & interest. This will impact the fund's performance.

Reinvestment Risk

When bonds in the portfolio mature or are called by the issuer, the fund manager must reinvest the proceeds. If prevailing interest rates are lower than those at the time of the original investment, the fund may experience a decline in overall portfolio yield.

Market Volatility

While corporate bond funds are generally less volatile than equities, they can still experience price fluctuations. Changes in market conditions and investor sentiment can impact the fund.

Limited Capital Appreciation Potential

Unlike equities, which have the potential for significant capital appreciation, corporate bond funds are more focused on capital preservation. Investors seeking substantial capital gains may find these funds less appealing.