Corporate Bond Funds: Meaning, Types, Returns, Who Should Invest

Manish Kothari

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Author is a Zfunds Verified Expert

Manish Kothari

Gurugram

What are Corporate Bond Funds?

Corporate bond funds are open-ended debt mutual funds making investments in bonds issued by corporates. It is a mutual fund that invests over 80 percent of its total assets in corporate bonds. Business companies sell these to fund their limited expenditure, such as requirements for working capital, marketing expenses, capital expenditure, etc.

Like equity shares, most debt instruments issued by corporations are listed on exchanges and can be traded. This enables the debt instruments to receive a reasonable value according to the company's dynamic economic scenario and credit rating. The Corporate Bond Fund purchases tradeable corporate debt documents and prices change according to the demand of a specific rated debt paper and changes in interest rates.

Types of Corporate Bonds

Corporate Bond Funds are commonly divided into two types:

Type One: Funds that invest only in debt securities of firms with high ratings (generally ‘AAA’), PSU companies and banks.
Type Two: funds that choose to invest in companies that are marginally lower-rated, typically 'AA-' and below.

Features of Corporate Bond Funds

Higher Returns

Corporate bond funds ensure significantly higher returns than other debt instruments in the market. The average yields based on YTMs as of October 2020 are between 5-7%.

2. Liquidity

Since most corporate debt instruments are easily tradeable, corporate bond funds have a high degree of liquidity.

3. Interest Rate Risk

The Corporate Bond Fund's portfolio is impacted by interest rate changes. The bond prices are inversely proportional to the change in interest rates. As interest rates rise, the price of bonds fall, and vice-versa. The extent of change in prices is dependent on the average maturity (measured through modified duration) of the fund portfolio. The higher the modified duration of a fund, the higher is the impact on the NAV in case of interest rate changes.

4. Credit Risk

Debt funds generally have lower risk when compared with equity funds. Within the debt fund category, corporate debt funds are considered relatively low risk, as these funds usually invest their assets in high rated corporate bonds or PSU bonds.

5. Tax Efficiency

Gains on corporate debt funds are taxed according to non-equity tax rates. If investments in corporate debt fund units are redeemed within 3 years from the date of purchase, then the investor has to pay short-term capital gains (STCG) tax on the gains. The STCG tax is as per the income tax slab of the investor. Hence, if the investor’s marginal tax rate is 30%, gains on the corporate debt funds are taxed at 30%. In case the units are held for more than 3 years from the date of purchase, the gains are subject to a 20 percent LTCG (Long Term Capital Gains) tax, with the benefit of indexation.

Corporate Bond Funds Returns

Corporate bond mutual funds perform like any other basic mutual fund. An increase in the value of the underlying corporate bonds in the mutual fund's portfolio, raises the fund's NAV, thus generating profits. A decline in the prices of the underlying holdings, on the other hand, has the opposite effect on the net value of the mutual fund.

Who should invest in corporate bond funds?

Corporate Bond Funds are suitable for investors seeking a fixed income on their returns along with a level of safety. Returns from such funds are usually predictable but are not guaranteed. Investors must match their investment horizon with the maturity of the fund before investing. Longer maturity funds can be subject to major price movements in times when interest rates turn volatile or change significantly.