The current market landscape is marked by volatility and uncertainty, leaving investors searching for ways to protect and grow their wealth. In such challenging times, bond investing has emerged as a popular choice for investors seeking stable returns with relatively lower risk compared to equities. The various types of corporate bonds have gained significant attention due to their potential for higher returns.
What are corporate bonds?
Corporate bonds are a type of debt security issued by companies, paying periodic interest and returning the principal at maturity. However, investing in corporate bonds carries risks, including default risk, interest rate risk, and liquidity risk. To mitigate these risks, investors should choose bonds issued by financially strong companies with high credit ratings. It's important to note that interest rates on corporate bonds can change over time and may be influenced by market conditions and credit ratings.
Why do investors turn to corporate bonds?
Income generation:Corporate bonds can generate income through periodic interest payments, making them attractive to investors seeking reliable income, such as retirees or those looking for fixed-income investments. Investors seeking higher yields may also consider corporate bonds to potentially enhance their investment returns.
Diversification: Corporate bonds can diversify an investment portfolio, reducing risk and mitigating market volatility when combined with other asset classes such as stocks and real estate. Including corporate bonds in a portfolio can enhance the overall risk-reward profile and performance of the portfolio.
Capital preservation: Corporate bonds are considered less risky compared to stocks and other investments, making them a potentially safer option for investors seeking to preserve capital and minimise investment risk.
Market volatility: During market volatility or economic uncertainty, corporate bonds can be sought after as a stable investment option. They provide a predictable income stream and are generally less impacted by short-term market fluctuations compared to other investment types.
How do corporate bonds work?
Corporate bonds have a defined term, known as the maturity date, which represents the date when the issuing company is obligated to repay the principal amount to the bond holders. Until the maturity date, bondholders typically receive periodic interest payments, known as coupon payments, based on the coupon rate specified at the time of issuance.
Coupon payments can be made annually, semi-annually, or in other periodic intervals, depending on the terms of the bond. The interest rate on corporate bonds is influenced by various factors, including market conditions, the creditworthiness of the issuer, and prevailing interest rates.
Types of debt investments
Individual bonds: Investors can buy corporate bonds individually from brokers, financial advisors, or online bond trading platforms. This allows them to select specific bonds that align with their investment horizon and risk tolerance. Investing in individual bonds provides the benefit of choosing bonds with maturity dates that match their investment goals, giving them greater control over the investment timeline.
Bond funds: Bond funds are diversified mutual funds that invest in a portfolio of bonds, providing diversification across issuers, maturities, and credit ratings. Managed by investment professionals, bond funds are a convenient option for investors who may not have the time or expertise to research individual bonds. They offer liquidity, allowing investors to buy or sell units on any business day, providing flexibility in managing their investments.
Bond ETFs: Bond ETFs are traded on stock exchanges, offering investors flexibility in managing bond investments with intraday liquidity. They provide potential diversification by holding a basket of bonds from different issuers, sectors, and credit ratings. Bond ETFs typically have lower management fees compared to actively managed bond funds.
How to invest in corporate bonds?
Investors can access corporate bonds through primary and secondary markets, mutual funds, ETFs, or managed accounts. In the primary market, bonds are purchased from the issuing company or underwriter during the IPO or bond issuance process. In the secondary market, existing bonds are bought and sold through brokers or bond exchanges, providing liquidity.
Maturity and Interest Rate Cycle
Maturity: Corporate bonds have fixed tenures with locked-in interest rates. Shorter-term bonds generally have lower rates and lower interest rate risk, while longer-term bonds may offer higher rates but are more exposed to market interest rate changes. Investors should assess their investment horizon and risk tolerance when selecting corporate bonds with different maturities, as it can impact potential returns.
Interest Rate Cycle: The interest rate cycle can impact corporate bond attractiveness. In a low-interest-rate environment, existing bonds with higher fixed interest rates may be more appealing, while in a rising interest-rate environment, newly issued bonds with higher interest rates may be more attractive. Monitoring interest rate trends and aligning bond investments accordingly can optimise returns from a corporate bond portfolio.
Taxation of corporate bonds
Taxation of interest income: Interest earned on corporate bonds in India is subject to income tax based on the individual's tax slab, treated as regular income and taxed at applicable rates. Awareness of the tax rate and slab is crucial for investors as it affects the net returns from corporate bond investments.
Taxation of capital gains:Capital gains from the sale of corporate bonds are subject to tax, with rates varying based on the holding period. Longer holding periods may result in lower tax rates, while shorter holding periods may attract higher rates. Investors must understand the tax implications of selling corporate bonds and seek advice from a tax professional or financial advisor as needed.
Recent interest rate hikes may present a favourable entry point into the bond market, with potentially higher yields on investment-grade corporate and other bonds. Despite offering higher yields compared to other fixed-income investments, corporate bonds also come with risks.
The primary risk associated with corporate bonds is default risk, which refers to the risk that the issuer may not be able to make interest payments or repay the principal when the bond matures. However, thorough research is crucial before making any investment decisions.
Nikhil Aggarwal is the Founder & CEO at Grip