What are corporate bonds? How do they work?

Consider this. You own a company that needs money for various projects and day-to-day expenses. There are two ways for you to raise this money; you can either sell shares of your company via stocks, or you can borrow money from investors by issuing bonds to them and promising a fixed interest over a fixed maturity period. The latter is called a corporate bond. One of the ways for the investor to lend you money is to invest in a corporate bond fund. And this is how debt funds work. Basically, you invest in them, and they lend money to either Government or corporates by investing in bonds.

A corporate bond is an instrument issued by a corporate to its investors. This is a way for the company to raise money, and in return, it promises the investors with a specific interest rate over a period of time. This time period is referred to as the maturity of the bond. For example, if you invest Rs 100 in a debt corporate bond at an interest of 5% and maturity of 5 years, then the corporate will pay you interest of Rs 5 every year and at the end of 5 years, will return your principal amount of Rs 100.

The corporate bonds are bought and sold in the corporate bond market, and this is where the trading (buying and selling) of corporate bonds is done. If you want to invest in corporate bonds, it is advisable to research thoroughly about the company that you are lending to. Each company is rated by various credit rating agencies on account of the likelihood of them returning your money. There is a possibility of a corporate borrowing money from you and then defaulting. This possibility is called credit risk. The higher-rated companies have low credit risk and vice versa. Hence, when investing in corporate bonds, to have a fair knowledge about the companies you are investing in is hygiene and may require some expertise. As compared to Government bonds, corporate bonds are riskier.

You can choose to invest in corporate bonds through the corporate bond funds, which are one of the types of debt funds, investing primarily in corporate bonds.

The price at which you purchase a single unit of the bond is called the bond price. These prices are subject to changes on the basis of the interest rate fluctuations and residual maturity period.

It is the interest expressed as a percentage of the face value of the bond, that was promised by the corporate to be paid to you.

The total return expected if the bond is held till its maturity is called yield-to-maturity (YTM).

The fluctuation of the bond price is the volatility associated with that bond. It tends to be higher for bonds with higher residual maturity.

Investments in higher-rated corporate bonds are relatively safer than lower-rated ones. But the possibility of relatively higher returns is more for the lower-rated bonds. The former’s returns may be stable in nature.

There are two ways to invest in a debt corporate bond

The corporate bond funds invest at least 80% of their corpus in AA+ and above rated corporate bonds

Corporate bond funds may invest in debentures and bonds of short-to-long-term maturity. It is advisable to keep the credit risk in mind when investing in any of the bond instruments, because any default can hamper the expected returns. Apart from the interest income generated by the bond itself, the fund may also benefit from the possible capital gains.

Investors with a relatively lower credit risk appetite can consider investing in corporate bond funds. Moreover, there is complete transparency in terms of where the money has been invested by the fund manager and about the investment objective of the fund, so that you can make an informed decision.

Want to know about other types of debt funds?