What are Corporate Bonds and How to Invest?
Private and public sector companies may sometimes need to raise funds for business requirements, such as the purchase of new equipment, expansion, building a new unit, etc. In these situations, they can seek loans from financial institutions or investors. To raise money from investors, companies issue corporate bonds.
This article takes a deep dive into corporate bonds, their types, benefits, who can invest in them, taxation and their limitations. Read on!
What Are Corporate Bonds?
Corporate bonds are debt securities similar to an IOU. Companies use them to raise money for business operations or expansion and investors use them to offer a loan to the companies and earn interest on the amount. It is a legal understanding between the investor and the company that the company will pay regular interest and return the principal on bond maturity.
Types of Corporate Bonds
Below are the different corporate bond types that investors can buy to fund public and private sector companies and earn interest on their investment:
- Zero-coupon Bonds: These bonds do not offer periodic interests but are available at high discounts. The difference between the bond value and the buying price is the investor’s profit, which is earned upon redemption at maturity.
- Convertible Bonds: Investors can convert these bonds to stocks depending on the underlying security of the bond. They are also known as hybrid bonds and do not attract interest after the investor has converted them to shares. This is because the bondholder becomes a shareholder upon conversion.
- Fixed-rate Corporate Bonds: These are also known as vanilla bonds and offer a pre-decided interest to investors. The rate is decided when the bonds are issued and stays constant until maturity.
- Floating Rate Bonds: The interest rate on these bonds is not constant and the bondholders earn interest based on the prevalent rates in the market and the company’s affordability.
- Investment Grade Bonds: These bonds are issued by financially stable companies and have very high credit ratings. Thus, the possibility of not getting the principal back is negligible.
- Junk Corporate Bonds: When companies that are struggling financially issue bonds, the risk of default is high. These are known as junk corporate bonds and offer high returns upon maturity.
Features of Corporate Bonds
Here are the features of corporate bonds in India:
- Investors must pay taxes on the returns of most corporate bonds
- Corporate bonds are classified based on their credit rating. Those with high credit ratings (AAA-BBB) are termed investment-grade bonds and carry a low risk of default. The other bonds that have a low credit rating are called non-investment grade or junk bonds and have a higher risk of default
- Corporate bonds have a coupon rate associated with them. Some have a fixed rate and some have a floating rate, which depends on the interest rate in the market
- Corporate bonds are commonly known as medium to long-term debt instruments. They have a tenure of more than 12 months. Those with a tenure lower than that are called commercial papers
- In case the investors do not wish to wait until maturity, they can sell the bond. The possibility of selling it easily without any negotiations is called liquidity and is moderate to high depending upon the bond
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Benefits of Corporate Bonds
Following is a list of the benefits of investing in corporate bonds:
1. Low Risk
Investment bonds are considered viable investment options because the risk is low compared to other investment vehicles like equity and mutual funds. However, this also depends on the credit rating of the bond and investors can choose based on their risk appetite.
2. Higher Interest Rates and Returns
Corporate bonds offer higher rates of return as compared to government bonds and thus the returns are also relatively higher.
3. Regular Interest Payments
Corporate bonds are ideal investment options for those who wish to create a regular source of income as they offer periodic interests until maturity.
4. No Impact of Inflation
The risk is also lower on corporate bonds because they are not impacted by inflation.
If the bond issuer goes bankrupt, bondholders hold a higher priority as compared to stockholders.
Why Invest in Corporate Bonds in India?
Corporate bonds offer better yields as compared to government bonds. They are a good way to diversify the investment portfolio because they pose low risk, offer predictable returns and help to protect the amount invested.
Who Should Invest in Corporate Bonds?
Corporate bonds are ideal for those looking for a low-risk investment option. Companies, retail investors and government organizations can invest in them.
How to Invest in Corporate Bonds?
Interested investors can buy corporate bonds through a broker, bank, or bond trader. Some corporate bonds can also be bought from other investors from the over-the-counter market.
Tax on Corporate Bonds
If the investor is holding a corporate bond for less than 3 years, they will have to pay short-term capital gains tax on the interest on their investment. This will depend on their tax slab. However, if the bond is held for over 3 years, the investor will have to pay long-term capital gains tax, which is 20% of the interest earned.
Returns and Risk of Corporate Bonds
- Returns: The returns on corporate bonds depend on the type of bond. If the interest rate is predetermined, the investors will get a fixed return. However, if it is floating, they will earn interest based on the prevailing market rate. There are also bond types that do not offer interest but sell at discounted rates, and the return is the difference between the face value of the bond and its buying price. It is noteworthy that any returns on corporate bonds are subject to tax.
- Risk: Corporate bonds are subject to market risk, interest rate risk, and credit risk. The bond issuer may also pay the bond amount before maturity. If this happens at a time when interest rates are going down, investors may not find new bonds with the same returns.
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Final Word
Corporate bonds offer better returns as compared to government bonds and thus can be a lucrative way to earn a regular income and preserve the investment. Investors looking to minimize their risk can opt for investment-grade bonds, whereas those with a higher risk appetite can choose non-investment-grade bonds.
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FAQs
Ans: ICICI bank corporate bond fund, Aditya Birla Sunlife corporate bond fund, HDFC corporate bond fund, and Sundaram corporate bond fund are some top-performing funds from 2022 and are expected to do well in 2023 too.
Ans: Indian corporate bonds help to preserve capital and also offer regular interest income. The risk associated with these bonds is low and, thus, they are regarded as good investment options.
Ans: In the primary markets, corporate bonds are sold through banks, brokerage firms or bond traders. Some corporate bonds are also available in over-the-counter markets.
Ans: Investing in corporate bonds can help to earn regular interest income and keep the capital safe. They are also not impacted by inflation. Thus, buying them can be a good way to diversify the investment portfolio.
Ans: Corporate bonds are generally regarded as safe investments. However, safety also depends on the type of bond. If the issuer is financially stable, the risk of default is negligible.
Ans: When investors buy a company’s stocks, they own equity in the company and earn dividends when paid. Investing in corporate bonds, however, doesn’t offer equity. So, corporate bond investors earn only interest and get back their principal. This doesn’t change even if the stock prices rise. In case of financial trouble, the companies are legally obligated to pay principal and interest on bonds. However, they may choose not to pay dividends to shareholders in such cases.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
