Are Corporate Bonds a Good Investment?
As an investor, you can look at corporate bonds, like any bond, except that this is issued by an existing company or corporate. Investing in corporate bonds is just like investing in any debt instrument or giving a loan to the company, which is the issuer of the corporate bond. All corporate bonds interest rate will be driven by market forces. However, apart from the market forces, the brand of the company and its rating also have a bearing on the corporate bond interest rate.
How can you buy corporate bonds? You can buy them in physical format or you can buy them in demat form. You can also buy these corporate bonds as part of the primary issue or as part of the secondary markets. There are different types of corporate bonds available in the Indian markets today based on the issuer, rating quality, maturity, features of the bond etc. In this section as we discuss whether bonds are a good investing, we also dwell at length on some of the key corporate bond risk factors that are the key to its evaluation.
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What exactly are corporate bonds?
Corporate bonds are debt products that are issued by the borrower and invested by the lender. In the case of corporate bonds, the company is the borrower and the bond investor is the lender. The main purpose behind the issue of corporate bonds is to help companies raise additional resources. This process is called disintermediation where the fund raising shifts from bank borrowings to directly raising funds through the issue of corporate bonds.
There are different reasons why companies borrow money through the issue of corporate bonds. Firstly, it helps them to have access to resources which can be invested at the right time when the opportunity arises. Secondly, more resources bolster the balance sheet and can be deployed in expansion, capital expenditure etc where the ROI will be more than the cost of issuing and servicing corporate bonds. Many companies also prefer to get their bonds listed on the stock exchange as it adds to the prestige of the issuing company and also enables them to get transparent pricing for the bonds issued.
When an investor invests in corporate bonds, they can look forward to two kinds of returns on their investment.
• Firstly, there is the regular interest usually paid annually or semi-annually by the corporate to the investors. Most bonds, by default, pay a fixed interest rate, although some variable-rate or floating, bonds also exist in India. In the case of variable rate bonds, the pay-out is decided based on a benchmark like the bond index or prevailing Treasury rate or the existing benchmark 10-year bond rate.
• Secondly, on maturity of the bond, which could range from 3 years to 10 years, the corporate will make full repayment of the principal along with the last tranche of interest. This is initiated as soon as the bond matures.
While bonds are issued and redeemed after a fixed tenure, all corporate bonds are required to be listed on the recognized stock exchanges by default. Hence if you are a bond holder, you can always sell these bonds in the secondary market subject to liquidity and proper pricing. Normally, in the case of illiquid bonds, the pricing tends to be skewed and exit can be rather difficult. Many corporate issuers of bonds also appoint market makers who will continuous provide two way quotes on these bonds to ensure liquidity flow available.
Here is why you should invest in Corporate Bonds
a) Corporate bonds can provide good source of regular income at attractive rates of interest. Since corporates also entail default risk, the returns offered on these corporate bonds is substantially higher than safer bonds. Normally, the yield son corporate bonds vary with the economic cycle, but in India, the corporate bonds typically provides about 200 bps more than what the government offers for similar maturity. That is for quality AAA rated issues. As you go down the rating line, the yield spread would be higher.|
b) Corporate bonds help you to diversify your portfolio. That is because, the debt instruments like bonds often act as a counterbalance to equities and , more often than not, they move in the opposite direction compared to stocks. This is very important for investors looking to build a rather balanced portfolio comprising of equity and debt as well as smaller sprinklers of other asset classes.
c) Corporate bonds can also offer capital gains. Since bond prices fluctuate, investors can take a vie on the interest rate movements and they buy or sell the bonds in the secondary market. These corporate bonds can actually offer opportunities to profit in volatile times in the bond market. Investors can even trade in and trade out of maturities and risk. You can take on more risk for higher returns or vice versa.
However, corporate bonds carry some key risks too
There are several risks that are visible in the case of corporate bonds. Here are some important risks that corporate bonds are vulnerable to.
• The first major risk in corporate bonds is the credit risk or the risk of default. In India, there have been several cases of default on corporate bonds, so it does remain a risk factor for corporate bond investors. For example, if the company gets into dire financial straits, its ability to pay interest or even repay principal could be hampered. This is more pronounced for companies with lower rated bonds.
• What if you are thrilled about locking in your money at high yields for 15 years and suddenly you find that your bond has been called? That is call risk. When companies raise funds at higher rates of interest, they insert a clause wherein they can call back the bonds if the interest rates fall too sharply. If you are investing in a corporate bond with premature call options, that is a big open risk for you.
• Enough has been written about liquidity risk, which is the risk that you cannot you’re your bonds. This is more pronounced when you are trading bonds in the secondary markets. In India, large parts of the corporate bond markets continues to be an OTC market as secondary market is quite limited.
• Price risk and inflation risk are two separate things but we combine them here for simplicity sake. Price risk is a systematic risk factor that is encountered by ever corporate bond investors. Any future interest rate rise will cause the market value of bonds to fall or depreciate to keep the market yields in sync with the market returns. The other related problem is the inflation risk, which is quite rampant today. Rising prices take away a good chunk of the real returns of the bond and that is a big risk.
As we conclude, here are two ways that you can invest in corporate bonds. The first is the direct method wherein you can directly purchase individual corporate bonds either in the primary market or the secondary market. The other way to invest in corporate bonds is through corporate bond funds or credit risk funds, wherein, the professional fund manager does the job of investing.
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