ALT Explainer: Breaking Down The Concept Of Corporate Bonds

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KEY TAKEAWAYS

1. Corporate bonds offer a middle ground between low-risk, low-return fixed deposits and high-risk, high-return stocks, providing balance and diversification to investment portfolios.

2. A corporate bond is a loan to a company in exchange for periodic interest payments and the return of the principal at maturity, with interest rates generally ranging from 10% to 14%.

3. Corporate bonds are less volatile than stocks, offering stable income and fixed maturity, making them a safer investment for risk-averse individuals.

4. Investing in corporate bonds provides access to large, established companies and often offers better returns than traditional investment options like PPF and bank FDs.

5. Corporate bonds also come with risks such as credit risk, interest rate risk, liquidity risk, inflation risk, and reinvestment risk, which investors must consider.

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Stocks and bank FDs are like the two extremes available in the investment space. On one hand, you can invest in the ‘low risk, low return’ fixed deposits with interest rates of around 3%-8%, and on the other hand, you can invest in the ‘high risk, high return’ stocks or equity mutual funds whose returns can go up to 10%-30% or even more, depending on the stock market volatility. But you can suffer losses too, right?

Now, are you secretly wishing if there is a mid-way out? Something between the boring but safe FDs and the risky but attractive stocks. Well, that is where investing in corporate bonds can give that much needed balance and diversification to your investment portfolio.

Sounds like a financial jargon to you? Fret not, as we deep dive and explain the concept of corporate bonds for your better understanding.

What Are Corporate Bonds?

Simply put, a corporate bond is essentially a loan that you give to a company in exchange for periodic interest payments and the return of your principal (the money you invested) when the bond matures at the end of the tenure. Interest rates on corporate bonds generally range around 10%-14%.

Not lets understand how corporate bonds work:

So, in short, corporate bonds allow companies to borrow money from investors, and in exchange, the investors receive interest payments and get their original investment (the principal) back after a certain period.

Are Corporate Bonds Similar To Bank FDs?

You may think that a corporate bond is similar to a bank fixed deposit or any other fixed‐return instrument. But that’s not true. Every type of investment is different in its own ways and has its own features, pros and cons.

When it comes to comparing corporate bonds with other instruments, let us take the the case of bank fixed deposits and stocks, and compare them with corporate bonds.

Who Can Issue Corporate Bonds In India?

In India, both public and private companies can issue corporate bonds. Moreover, a company incorporated in India, but part of a multinational group, can also issue corporate bonds. However, a company that has been incorporated outside India cannot issue corporate bonds in India. A statutory corporation such as LIC (Life Insurance Corporation) too is eligible to issue corporate bonds.

Why Do Companies Issue Corporate Bonds?

Companies can issue corporate bonds primarily for two reasons:

• Raise capital without giving up ownership: Unlike the case of stocks wherein existing shareholders’ ownership gets diluted, a company can avoid giving up any control or ownership by issuing bonds.

• Diversifying ways to raise capital: Typically, bonds are an alternative source of capital. Any firm wouldn’t want to be too much dependent on one source of capital like borrowing from traditional banks.

How Much Does An Investor Earn From Corporate Bonds?

Why Invest In Corporate Bonds?

Now that you have got a fair idea about corporate bonds, let's bring to you the list of key benefits of investing in corporate bonds:

1. Stable Income & Fixed Maturity

Corporate bonds have a fixed maturity date such as 15 months, 2 years, 9 months, etc, implying that you know exactly when you’ll get your principal investment back, assuming the company doesn't default. This can be appealing if you want a predictable return of your capital.

And until the maturity period arrives, the bonds provide fixed interest payments (coupons) over the life of the bond. These payments can be typically made monthly, annually or semi-annually, making them a predictable and stable source of income.

2. Lower Risk Than Stocks

As corporate bonds are fixed income securities, they are generally less volatile than stocks and equity mutual funds. While stock prices can fluctuate wildly and frequently, bond prices tend to move more gradually. This can make bonds a safer investment if you’re risk-averse and prefer more predictable returns.

Also, in case a company goes bankrupt, bondholders are given priority, and will have a higher claim on the company’s assets compared to shareholders. This means that bondholders are more likely to get some of their money back in a liquidation scenario, although they would still face the risk of default.

3. Diversification For Your Portfolio

Like we mentioned earlier, bonds act as a mid-way between bank FDs and stocks, right? So, when you invest in corporate bonds, they add a degree of diversification to your investment portfolio and help reduce the overall risk.

For instance, during times when stock markets are down, bonds may provide the much needed stability to your portfolio.

4. Better Returns Than Many Traditional Investment Options

If you compare with the traditional investment options such as PPF and Bank FDs, corporate bonds often offer better returns.

For example, the current interest rate of PPF is 7.1% p.a., and that of bank fixed deposits ranges widely in the range of around 3%-9% p.a. When we look at corporate bonds, their returns can range around 10%-14%, which is higher than the traditional ones, isn’t it?

5. Access To Large & Established Companies

When you invest in corporate bonds, you get access to the debt side of the large and established companies, known as blue-chip companies. These companies have typically remained financially stable and have a proven track record of paying back their debt. This allows investors to gain exposure to such companies without having to directly invest in stocks, which tends to be more volatile.

Risks Associated With Corporate Bonds

While corporate bonds have many benefits, there are some risks that investors must be aware of:

• Credit Risk: The biggest risk is that the company might default on its bond payments. Companies with lower credit ratings (or those that are financially unstable) pose a greater risk.

• Interest Rate Risk: If interest rates rise, the value of existing bonds tends to fall. This is especially important if you're planning to sell the bonds before maturity.

• Liquidity Risk: Some corporate bonds may be hard to sell quickly, especially those issued by smaller companies or in illiquid markets.

• Inflation Risk: If inflation rises significantly, the real value of your fixed coupon payments can decrease, reducing the purchasing power of your bond income.

• Reinvestment Risk: Reinvestment risk is the probability that an investor will not be able to reinvest cash flows, such as coupon payments, at a rate equal to their current return. Such risk can arise in case your bonds contain a clause that allows the issuer to redeem before the due date/maturity, i.e. do a prepayment. This can force investors to reinvest at the current market interest rates, which usually tend to lower than the ones at which you had earlier invested.

Conclusion

Investing in corporate bonds can be a good strategy for those seeking stable income, portfolio diversification, and a predictable return on investment. Bonds offer lower risk than stocks and can be tailored to different risk profiles, making them an attractive option for conservative investors or those looking to balance their portfolio with fixed income investments.

However, like most investment options, corporate bonds too come with their own set of risks, which investors must weigh against potential returns. So always practise due diligence before putting your money into bonds or any other investment option. After all, it's better to be safe than sorry, right?

If you would like to learn more about corporate bonds, you can join the ALT Investor community here. We have various industry experts as part of this group who can help you with your queries.

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Please note that this is an opinion blog and not an official research or investment advice. This blog aims to help retail investors make an informed decision if they are interested in real estate debt as an asset class, and neither encourages nor discourages you from investing in any particular asset class or platform.