What are Corporate Bonds?

We all know that we can create wealth from the stock market in the long run. But along with high returns, comes high risk. To reduce risk, investors turn towards bank fixed deposits. But they too have lost their charm because of low interest rates. Now retail investors like you and me might feel stranded about where to invest to earn inflation beating returns at low risk? Well, I have found a way out for you. The solution lies with corporate bonds. Now, you must be wondering what are corporate bonds and how do you invest in them? Don’t worry as we will explore it all in this article. So, let’s begin. In this article:

1. What are corporate bonds?
2. Types of corporate bonds
3. Credit ratings of corporate bonds
4. How can you buy corporate bonds?
5. Why does the coupon rate change in the secondary market?
6. Advantages and disadvantages of corporate bonds
7. Tax implications on bonds
8. Are corporate bonds the right investment option for you?

What are Corporate Bonds?

Companies need money for various reasons such as future expansion or to launch a new product. So, they constantly look for ways to raise capital. One such way is issuing stocks. But by doing so they will have to dilute their equity ownership. Another way is to take a loan from a bank. But lending rates of banks are way too high. So instead of taking a loan from the bank, the company decides to take a loan from retail investors like you and me by issuing corporate bonds. So, a corporate bond is an agreement between the company and the investors. Here, the company borrows money from retail investors and promises to pay a fixed rate of return on the principal amount. Say for example, Infosys has issued a bond with a face value of Rs 1,000. The bond will mature after 10 years and pay a coupon of 8% per annum. So, every year on a fixed date Infosys will pay you 8% interest on your invested amount i.e. Rs 80 and return your principal amount upon maturity of the bond. To know the basics of bonds – Click here. Recommended watch: What are bonds?

Types of Corporate Bonds

1. Fixed-Rate bond This is the most common type of corporate bond. The issuer of the bond promises to pay a fixed coupon rate till maturity. For example, Mahindra & Mahindra Financial Services Ltd. had issued a fixed rate bond in 2016. It will mature after 10 years in 2026 and is providing an annual coupon of 9%. 2. Zero Coupon bond Zero-coupon bonds do not provide coupons or interest. Instead, they are issued at a discount to their face value.  Upon maturity, the bond is redeemed at par. So, the difference between the discount rate and the face value is the earnings of an investor. For example, suppose Reliance Industries issues a bond with a face value of Rs 1,000. It is sold at a discounted value of Rs 750 and will mature in 5 years. Upon maturity, the investors will redeem the bond at the face value of Rs 1,000. The profit made by the investor is the difference between the face value and discounted rate. In this case, it is Rs 250. 3. Tax-free bond These bonds are issued by public sector undertakings (PSUs) with the motive to raise funds for an upcoming project. The interest you earn from these bonds is completely exempt from tax under section 10 of the Income Tax Act, 1961. These bonds are highly preferred by individuals who fall under the higher tax bracket. Rural Electrification Corporation Limited (REC) is one example of a tax-free bond. The bond will mature in 2028 and is providing a coupon rate of 8.46% per annum. 4. Callable bonds Callable bonds are bonds in which the issuer has the option to redeem the bond before the maturity date. These bonds provide a higher coupon rate as compared to non-callable bonds. For example, in February 2019 IIFL Finance Ltd. had issued a callable bond with a coupon rate of 10.24% per annum. It has a call date of February 2024. So, IIFL Finance Ltd. has the right but not the obligation to redeem the bond before the maturity date. 5. Convertible bonds The issuer of a convertible bond has the right to convert the bond into equity shares on the date of maturity. During the 1980s Reliance Industries used to raise additional capital by issuing convertible bonds. So, on the date of maturity, the bonds would be converted to an equivalent number of shares according to the current share price of reliance. 6. Secured and unsecured bonds Bonds are divided into two – secured and unsecured. Secured bonds are backed by the company’s assets. Whereas, unsecured bonds don’t have collaterals. So, if you invest in a secured bond and the company defaults its payment, you can claim the asset of the company for repayment of the principal amount. Whereas, if you invest in an unsecured bond and if the company defaults, then you cannot claim the company’s assets. These are riskier than secured bonds and hence offer higher coupons. While investing in an unsecured bond, you must look at the creditworthiness of the borrower (company). Let’s take a look at the interest rate offered by secured and unsecured bonds.

Company	Security	Credit Rating	Current Yield
India Infradebt Ltd.	Secured	AAA Crisil rating	5.12% per annum
Indian Railway Finance Corporation Ltd.	Secured	AAA Crisil rating	6.88% per annum
ICICI Home Finance Company Ltd.	Unsecured	AAA Crisil rating	7.99% per annum
Fullerton India Credit Company Ltd.	Unsecured	AAA Crisil rating	7.42% per annum

From the table above we can clearly see that while unsecured bonds may provide a higher rate of return, they carry high risk too.

Credit Ratings of Corporate Bonds

Previously companies and high net investors (HNIs) used to invest in bonds. But today retail investors have also been given an opportunity to invest in bonds. But with very little information about the company how would you understand if the company is genuine or not? To make the investment process simpler, credit rating agencies rate each and every bond based on its creditworthiness. Here is a list of the most common credit rating agencies. CRISIL – Credit Rating Information Services of India Ltd. ICRA – Investment Information and Credit Rating Agency of India Ltd. CARE – Credit Analysis & Research Ltd. They provide credit ratings to bonds.

Ratings	Risk
AAA	The bond has the highest degree of safety and low credit risk
AA	The bond has a high degree of safety and low credit risk.
A	The bond is adequately safe and have low credit risk
BBB	The bond is moderately safe and has moderate credit risk
BB	The bond has a moderate risk of default
B	The bond has a high risk of default
C	The bond has very high risk of default
D	The security has already defaulted or is expected to default soon

Please note: Credit rating agencies use modifiers such as plus or minus. Thus the rating of AA+ is one notch higher than AA, while AA- is one notch lower than AA. Click here to explore more about credit ratings.

How Can You Buy Corporate Bonds?

Corporate bonds could be bought in three ways.

1. Invest in a new issue
2. Invest via secondary market
3. Invest in corporate bond funds

Let’s take a look at each of them. 1. Invest in a new issue When a company is in need of funds they issue bonds in the primary market this is known as a new issue bond. It is when the bond is offered to the general public for the very first time. 2. Invest through secondary markets If you miss the opportunity of investing through the primary market, then you have an alternative to purchase the bond from an existing bondholder through the secondary market. These bonds are listed and are traded in stock exchanges – National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). 3. Invest in corporate bond funds Securities and Exchange Board of India (SEBI) defines corporate bond funds as the funds that invest 80% of their corpus in AAA rated debt instruments. These funds are suitable for investors who have a low risk appetite. Here are a few corporate bond funds:

Fund	Rating	1 Year Returns	3 Year Returns	5 Year Returns
Aditya Birla Sun Life Corporate Bond Fund – Growth-regular Plan	5 star	6.06%	9.23%	8.25%
Nippon India Corporate Bond Fund – Growth Plan	5 star	6.68%	7.78%	7.43%
ICICI Prudential Corporate Bond Fund	4 star	5.26%	8.49%	7.74%
Axis Corporate Debt Fund	4 star	5.59%	7.77%	–

 

Why Does the Coupon Rate Change in the Secondary Market?

The coupon rate is the interest rate or the yield you receive on the bond. As the price of a bond fluctuates in the secondary market, its yield also changes. For example, a company issues a bond in the primary market with the face value of Rs 1,000 which provides a 10% yield. The bondholder will receive Rs 100 as an annual yield. Now in the secondary market, the bond is trading at Rs 1,200. That is Rs 200 premium. But, the yield amount you will receive is still Rs 100. So in this scenario, the percentage of yield has decreased to 8.33% (100/1200 x 100). Assume that the bond is trading at Rs 800. That is a discount of Rs 200 to its face value. Now the yield amount you will receive is still Rs 100. But the percentage of yield will change to 12.5% (100/800 x 100). So according to the price you purchase the bond, the yield varies.

• If you purchase the bond at a premium to the face value, you will receive a low yield.
• If you purchase the bond at a discount to the face value, you will receive a higher yield.

Yield is commonly measured in two ways: Current yield and yield to maturity. Current yield – It is the annual return you would get if you purchase the bond today from the secondary markets. Yield to maturity – It is the total returns you will receive on the bond if you hold it till maturity. This is a great tool as it helps you compare one bond’ with another and make a wise decision. Here is a list of all the listed corporate bonds.

Advantages of Corporate Bonds

1. High returns: Corporate bonds pay a higher yield as compared to bank FDs and government bonds. For example, the current interest rate provided on FDs is around 5.5% and government bond provides 6% returns. But the corporate bond of L&T Finance Ltd. provides 8.8% interest and is AAA rated by CRISIL and CARE. 2. Low risk: Before you invest in any corporate bond you must check the credit rating of the bond. Always look for AAA+ rated or AAA rated bonds as they are considered safer and there is a low risk of default. 3. Liquid: Corporate bonds are listed on the stock exchanges. So, it can be bought and sold with ease. 4. Duration: These bonds have a shorter duration as compared to government securities. They usually come with a duration of 60 months or 120 months.

Disadvantages of Corporate Bonds

1. Credit risk: This is one of the major risks in a corporate bond. If the issuer of the bond goes bankrupt and defaults in payment, then you are at great risk. Hence, you must always invest in secured and AAA rated bonds. 2. Costly: Few bonds carry a minimum investment amount which ranges between Rs. 1 to 2 lakhs and not everyone can afford to invest in these. On the other hand, there are a few affordable investment options too. For example, Edelweiss financial services Ltd. has recently launched a 120-month bond which has a minimum investment amount of Rs 10,000. The offer will close on 6th September 2021. It is A+ rated by ICRA.

Tax Implications on Bonds

The interest you earn on a corporate bond is considered as income from other sources and is taxable. For Listed bonds: 

• If you sell the bond before a year in the secondary market, then you have to pay short term capital gains (STCG) as per your tax slab.
• If you sell the bond after a year but before maturity, then you are eligible to pay long term capital gains (LTCG) at 10% without indexation.

Unlisted bond: 

• If you sell the bond before 36 months (3 years), then you are eligible for short term capital gains as per your tax slab.
• If you sell your units after 36 months (3 years), then you are eligible for long term capital gains of 20% without indexation.

For Corporate Bond Funds: 

• If you sell your units before 36 months, then you are eligible for short term capital gains as per your tax slab.
• If you sell your units after 36 months, then you are eligible for long term capital gains of 20% with indexation.

Are Corporate Bonds Right for You?

The answer is a big YES. Corporate bonds are the ideal investment option for those who are looking for inflation beating returns with low risk. And if you are a few years away from achieving a financial goal or are heading towards retirement then it’s time to shift towards a less volatile investment option. So that you can enjoy capital preservation with good returns. If you are in your 20s then you can diversify a small portion of your portfolio towards bonds. By doing so, you can even out the volatility of stocks. Always remember to check the credit rating of a bond before investing. You should only invest in only AAA+ or AAA rated bonds. But to invest in corporate bonds having a Demat account is a must. Samco’s Demat account provides you with quick and hassle free trading at your fingertips. Open a Demat account at Samco today!