This article talks about everything you need to know about corporate bonds.
An individual has several investment options where they can put their hard-earned money. Individuals choose among these options in accordance with their financial goals and risk appetite. Investors looking for financial investment options that offer fixed returns can opt for investment bonds. Within investment bonds, they may choose from Central Government Bonds, State Government Bonds, Public Sectors Bonds, or Corporate Bonds. All these financial instruments offer guaranteed and fixed returns, usually have a fixed tenure, and suffer from low liquidity.
What are Corporate Bonds?
Corporate bonds in simple words are debt securities issued by a corporation to raise money for various purposes like purchasing equipment, expansion of business, etc. When someone invests their money in bonds, they in effect lend money to the issuing company. In return, the company promises to return the money on predetermined maturity date, and they usually pay interest at a fixed rate. Interest is generally paid semi-annually by the company. Corporate bonds, unlike equity shares, do not give ownership interest to the investor in the issuing company. The issuing company also issues an IOU or an acknowledgment of debt to the bondholders, and thus they are legally bound to repay the borrowed money. As corporate bonds are riskier compared to government bonds, they offer a higher rate of interest than them.
Why should you invest in Corporate Bonds?
An investor should invest in corporate bonds because of the following benefits offered by it:
- Higher Returns: Corporate bonds have greater potential to generate higher returns for their investors. Investors by investing in corporate bonds undertake greater risk as compared to government and other bonds. Hence, the higher the risk, the higher is the return. Also, large corporations have higher growth potential, similarly, these bonds also grow at a greater pace. Additionally, reputed and high credit-rated companies make regular coupon payments to their investors.
- Liquidity: Although corporate bonds have a fixed maturity period, they may also be listed on the secondary markets i.e., stock exchanges or may trade Over the Counter (OTC). Hence, anyone can buy and sell these securities at any time (even after their issue) till they mature. This provides liquidity and flexibility to the investors.
- Coupon Structure: Corporate bonds have different maturities and coupon structures, providing investors the option to choose from as per their needs. Corporate bonds can be long-term, medium-term, short-term, or perpetual bonds. At the same time, investors can choose from fixed-rate, floating-rate, and zero-coupon bonds.
- Diversification Benefits: Normally, high-quality corporate bonds are considered a safe and conservative investment option. Thus, investors building balanced and diversified portfolios can add bonds to offset their riskier investments in stocks. As bonds are less risky than equity shares, it helps an investor to balance the risk in the investor’s portfolio.
- Tax Benefits: Generally, corporate bonds are considered long-term investments with durations greater than 3 years. In India, long-term investments have tax advantages as Long Term Capital Gains (LTCG) is taxable at 20% with the benefit of indexation. It is specifically beneficial for investors falling under the highest tax bracket.
What are the Risks and limitations of Corporate Bonds?
As with any other financial instrument, corporate bonds are also not free from risk and limitations, which are as follows:
- Default Risk: As these securities are debt instruments, they suffer from credit or default risk. Lower-rated bonds lure investors with higher interest rates, but they carry high credit risk. High-rated bonds have low default risk, but it does not guarantee anything.
- Interest Rate Risk: Corporate bonds are long-term investments and, in this period, interest rates in the market keep fluctuating. The value of the bond and the interest rate are inversely related to each other.
- Liquidity Risk: Unlike equity stocks and government bonds, the market for corporate bonds is relatively thin. Low buying interest in a corporate bond leads to price volatility of that bond. There is always a risk that investors will be forced to sell their bonds at a lower price.
- Inflation Risk: Corporate bonds may carry a fixed or variable rate of interest with them depending upon the type of bond. There is a risk that inflation may rise at a faster pace than the rate of interest on bonds. In this case, investors are earning a negative real rate of returns, which may erode their investment.
- Lower Return than Equities: The returns from corporate bonds may not match the returns of equities for the same tenure as equity have more upside growth potential as compared to the bonds. Investors might feel that they have lost an opportunity to earn higher returns by investing in debt securities.
What are the different types of Corporate Bonds?
There are several types of corporate bonds in India. Corporate bonds can be categorized on the basis of their convertibility into convertible and non-convertible Bonds. Corporate Bonds are categorized as Type One bonds (high-rated companies) and Type Two bonds (low-rated companies) based on their credit ratings. Based on the duration of the bonds they are classified as Short-term (Less than 1 year), Medium-term (1-5 years), and Long-term (More than 5 years) Maturity Bonds. And finally based on Bond’s coupon structure they can be Fixed-rate, Floating-rate, or Zero-coupon Bonds. Let us understand a few major types of corporate bonds in detail:
- Convertible Bonds: This type of corporate bond gives an investor the right to convert them into shares of the company. Investors can exchange these bonds for a predefined number of stocks of the issuing company at their disposal after a certain period of time.
- Zero-Coupon Bonds: This type of corporate bond does not pay any amount of interest to the investors. Instead, they trade at a higher rate of discount. The return is paid to the investor in the form of the profit that comes with the maturity of the bond.
- Junk Bonds: It is not exactly a type of bond, but a widely used term for corporate bonds with low credit ratings carrying higher interest rates and higher risk.
- Floating-Rate Bonds: This type of bond has a flexible coupon rate, which is reset periodically in accordance with the benchmark rate.
How can you invest in Corporate Bonds in India?
As an investor, you can invest in corporate bonds in India in two ways.
- Through Brokers: Investors can trade in individual corporate bonds through their brokers. This method requires investors to carry their own research on the companies that offer corporate bonds. Also, investors will need to ensure that their portfolio is adequately diversified among bonds of different companies and sectors to optimize their bond returns.
- Through Mutual Funds: Investors can also invest in corporate bonds through mutual funds or exchange-traded funds that focus on them. Mutual Funds have their own advantages such as benefits of diversification, professional management, and a different set of risks than individual bonds.
Summary
It is often noticed that risk-averse investors prefer to invest in government bonds, index funds, treasury bills, etc. rather than corporate bonds. Though corporate bonds carry its fair amount of risk, at the same time it also offers greater returns. All types of investors should consider investing in corporate bonds. Instead of avoiding corporate bonds, investors should be careful and cautious while investing in them. They should carry proper research on issuing companies checking for their credit ratings, past default history, average returns, and so on. A corporate bond provides you with a good diversification option, and thus you should invest in them after thorough analysis.