Are corporate bond funds a potential alternative to bank FDs?

Bank fixed deposits (FDs) have traditionally been the most favoured debt investment option among Indians. But not anymore. With interest rates on FDs falling, especially over the past one year, their popularity is waning. In such times, corporate bonds can serve as an alternative to bank FDs for investors looking for low-risk investment options.

Also known as non-convertible debentures, corporate bonds are debt instruments issued by companies as an alternative to bank loans. Safety of corporate bonds can be evaluated from the credit ratings issued by rating agencies. Issuers with AAA rating have the highest safety and lower credit risk than those with AA rating.

Table 1: Credit ratings for different instruments

Credit ratings for different instrumentsET Online

Note: CRISIL may apply ‘+’ or ‘-‘ signs for ratings from ‘CRISIL AAA’ to ‘CRISIL C’ in long-term debt instruments and for ‘CRISIL A1’ to ‘CRISIL A4’ in short-term debt instruments to reflect comparative standing within a category
For illustrative purposes. Source: CRISIL

Corporates compensate investors for the credit risk on these bonds by offering higher yields compared with government bonds. Thus, lower rated bonds (AA+, AA, AA- and A+) provide higher yields and spreads over comparable government bonds and higher rated bonds (AAA), but carry higher credit risks.

Table 2: Yield matrix across rating categories

Yield matrix across rating categoriesET Online

Source: CRISIL, Data as on 31st December 2020.

Selecting 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.

How Corporate Bond Funds work
Corporate Bond Funds are debt mutual fund schemes which invest in corporate bonds or non-convertible debentures. As per SEBI’s mandate, corporate bond fund must invest at least 80% of its assets in highest rated corporate bonds. Since Corporate Bond Funds invest predominantly in highest quality instruments, the credit risk of these funds is relatively lower compared to other debt funds which may invest in lower rated instruments.

Why Corporate Bond Fund?
High on safety
As Corporate Bond Funds are required to take most of their exposure in top rated debt instruments, they are high on safety compared with most other debt fund categories

Higher Liquidity
Being heavy on top rated papers boosts the liquidity aspect of these funds, which helps the fund manager to rebalance the portfolio more efficiently.

Steady performance
Even during the recent financial market upheaval, Corporate Bond Funds have posted steady returns compared with other debt categories.

The chart below shows the 1 year average category returns of Corporate Bond Funds versus some other popular Debt Fund Categories (as 5th Jan, 2021).

Average category returns of various debt mutual fundsET Online

Source: Advisorkhoj Research (as on 5th January 2021).
Disclaimer: Past performance may or may not be sustained in the future

Tax benefit
Investing in Corporate Bond Funds for a period exceeding three years qualifies for long-term capital gains tax at 20% with indexation. This makes corporate bonds a good alternative to FDs for investors belonging to the highest tax bracket, as FD returns are taxed as per income tax slabs.

Corporate Bond Funds in portfolio allocation
Depending on your investment needs, your debt portfolio should have a combination of funds of different duration profiles ranging from a few months, to 2 – 3 years to longer investment tenures. Your debt portfolio should also have a combination of highly rated money market instruments, highly rated corporate bonds and G-Secs. Corporate Bond Funds are suitable for 3+ year investment tenures. If you have a 3 plus years investment tenure you can get the benefit of long term capital gains taxation in debt funds. Corporate Bond Funds can be part of your core debt fund portfolio. These funds may provide stable returns, with limited downside risk and higher post tax returns over sufficiently long investment tenures.

Investors should consult with their financial advisors if Corporate Bond Funds are suitable for their
investment needs.

(The author is the head-product, marketing and communication, Mirae Asset India)


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