Understanding corporate bond funds

You should be aware that mutual funds invest not only in stocks but also in debt products. Investors should select only mutual funds that match their risk tolerance. One such product is corporate bond funds that are debt funds and required by regulation to invest at least 80% of their assets in corporate bonds with the highest credit rating of AAA.

Companies with a high rating are usually financially sound and have a good chance of repaying their creditors on time. As per the Value Research data, corporate bonds have given returns of 4.84%, 8.16%, and 7.46% over one, two, and three years, respectively. Let’s understand in detail:

What are corporate bond funds?

Corporate bond funds are debt funds and are required by regulation to invest at least 80% of their assets in corporate bonds. Corporate bond securities are the underlying portfolios of credit opportunities for debt mutual funds.

Corporate bonds can be issued by any corporation. Organisations and businesses require capital to run their day-to-day operations and expand and thrive in the future. Companies can achieve this in two ways: debt and equity instruments.

Debt is a safer option because it does not immediately harm the company’s stockholders. As a result, most businesses prefer to raise cash through issuing debt instruments.

Bank loans can be costly for businesses depending on their requirements. Bonds or debentures are used to offer organisations a cost-effective way to raise capital.

When you buy a bond, you are essentially lending money to the corporation. The firm will repay the principal at the end of the agreed-upon maturity period. Meanwhile, you will be paid interest (a fixed amount of money), referred to as a coupon. In India, coupon payments are usually made twice a year.

Taxation aspect of corporate bond funds

The increase in the value of mutual fund units is taxable as “Income from capital gains.” For tax purposes, corporate bond funds with at least 80% of their holdings in debt instruments will be categorised as non-equity oriented mutual funds.

-The gains from these funds are classified as either Short-Term Capital Gains (STCG) or Long-Term Capital Gains (LTCG), depending on how long the mutual fund units were held.

-If the holding period is less than 36 months, the profits are taxed as STCG at the investor’s regular tax rates. However, gains that have been held for 36 months or more are considered as LTCG and are taxed at 20% (with applicable cess and surcharge) with indexation. The indexation advantage reduces the overall tax burden for investors who get such returns.

Should you invest in corporate bond funds?

Corporate bonds are a better option for investors who want a steady but higher income from a safe investment. When opposed to debt funds, corporate bonds are a low-risk investment vehicle since they ensure capital protection. These funds, however, are not entirely risk-free.

That said, corporate bonds are less volatile than credit risk funds, which have the highest risk. Further, as the remaining 20% of the assets can be invested in low rated debt papers, this fund can witness the risk of default in payment.

Corporate bond funds that invest in high-quality debt securities can help you achieve your financial goals more effectively. When interest rates fluctuate more than expected, long-term debt funds become riskier. As a result, to mitigate volatility, corporate bond funds invest in stocks.

Points to remember before investing

Corporate bond funds invest in medium to long-term corporate debentures and bonds. As a result, consider it a long-term investment vehicle.

A basic understanding of the market is required. It will be difficult to spot potential risk and the market if you are not a seasoned debt fund investor.

Keep in mind that a significant number of defaults in a fund’s portfolio might cause a significant drop in returns. If you decide to invest in them, don’t be swayed by the previous year’s performance.

One should stick to the offerings of large AMCs, especially the top five funds, when it comes to corporate bond funds.