Corporate Bond Funds – A Professional Investment Avenue

Corporate bonds defined

Corporate bonds, also known as non-convertible debentures (NCDs), are debt securities issued by companies to raise finance. In case of corporate bonds the credit safety can be generally gauged by credit ratings issued by credit rating agencies. Issuers with AAA rating have the relatively highest safety and lower credit risk than those with AA or below rating. Corporates compensate investors for credit risk by offering higher yields on low rated bonds. As seen in the second table, owing to higher credit risk, lower rated bonds (AA+, AA, AA- and A+) provide higher yields.

Credit ratings of different instruments

CRISIL may apply '+' (plus) or '-' (minus) signs for ratings from 'CRISIL AA' to 'CRISIL C' in long-term debt instruments and for ratings from 'CRISIL A1' to 'CRISIL A4' in short-term debt instruments to reflect comparative standing within a category. Source: CRISIL Notes: G-sec and corporate bonds data as of May 7, 2019 1 year G-Sec is represented by 6.65% CGL 2020; 3 year G-Sec is represented by 8.13% CGL 2022; 5 year G-Sec is represented by 7.32% CGL 2024; 10 year G-Sec is represented by 7.26% GS 2029 Source: CRISIL Research

Choosing the right bond can be daunting for retail investors as they do not have sufficient skill, knowledge or the time to track the market. Instead, they can opt for Corporate Bond Funds.

Corporate bond funds demystified

Corporate bond funds are open-ended mutual funds that invest predominately in highest rated corporate bonds. As per Securities and Exchange Board of India (SEBI), minimum 80% of the total assets should be invested only in AA+ and above rated corporate bonds. The fund may invest a small portion in government securities (G-secs). The following chart shows the credit quality analysis of CRISIL-ranked corporate bond funds for the quarter ended March 2019 - corporate bond funds have invested 72% of their portfolio in AAA-rated papers, 4% each in A1+ and G-secs in March 2019.

Credit rating profile of the corporate bond funds

Others include cash and cash equivalents CRISIL-ranked corporate bond funds for the quarter ended March 2019 used for analysis Portfolio data of March 2019 Source: CRISIL Research

These funds typically follow the accrual strategy, wherein the target is to generate high returns through high accrual of interest on bonds which are mostly of shorter duration and are held till maturity. These funds are less exposed to volatility of the interest rate.

Accrual and duration strategy

In case of accrual funds, the fund manager aims for higher returns by investing in shorter duration bonds with lesser focus on capital appreciation. The search for returns is dictated by a trade-off between yield that the fund manager can get on corporate bonds and the credit risk he is taking by buying higher interest-bearing (and possibly lower credit-rated) corporate bonds.

On the other hand, duration-based funds strive for capital appreciation by taking calls on the interest rate movement. The fund manager increases portfolio duration for capital appreciation when interest rate falls and decreases duration to protect from capital losses when rate rises.

Performance

Traditional avenues generally offer steady returns, while corporate bond funds offer an opportunity to capture relatively higher returns, albeit at a higher risk. Corporate bond funds represented by CRISIL Short Term Corporate Bond Index returned 8.29%*, on average, over three years ended April 2019 compared with 7.88%^ average returns by the three-year FD index over the same period.

Notes: Past performance may or may not be sustained in future.

^*Daily average rolling returns over three years of CRISIL Short Term Corporate Bond Index since inception (March 31, 2002) till the period ended April 30, 2019

^{^} Daily average rolling returns over three years of three-year FD index since inception of the CRISIL Short Term Corporate Bond Index (March 31, 2002) till the period ended April 30, 2019

Three-year FD index has been calculated by considering the simple average of FD rates of the top three (by total deposits) public and private sector banks

Source: CRISIL Research

Fitment

Corporate bond funds can be considered as an investment alternative for investors with a moderate risk profile and medium-term investment horizon of 3-5 years. Like other debt mutual funds, investment in corporate bond funds for a period exceeding 3 years qualifies for long-term capital gains tax at 20% with indexation. However, investment in high-quality bonds does not indicate that they are risk-free. Rating downgrade of bonds is likely to impact fund’s returns subject to its weightage in the portfolio. Hence, investors need to carefully evaluate the portfolio attributes before investing, to gauge the concentration risk, credit risks and other risks. Investors shall always refer to the Scheme Information Document and Key Information Memorandum of the schemes carefully to understand the detailed risk factors associated with the scheme. Information regarding the same is available in the public domain or investors can seek the help of a financial advisor also.

Disclaimer:

Any comparison mentioned in this material is for general information only and not intended to be relied upon as investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Information and content herein have been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. Recipient are advised to seek independent professional advice before making any investments. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. SBI Mutual Fund / SBI Funds Management Private Limited is not guaranteeing or promising or forecasting any returns.

In view of the individual nature of the financial or tax consequences, each investor is advised to consult his/her own financial/tax consultant with respect to specific tax implications arising out of their participation in investments. The tax rates are as per current tax laws and are subject to change.