When companies need to fund expansion or new projects, they have several options for raising capital. One is to issue shares, which dilutes equity. Another option is to borrow from banks, but interest rates can be high. Instead, they can borrow from investors by issuing corporate bonds. A corporate bond is essentially a contract between a company and its investors. The company borrows money from investors and agrees to return the principal amount with interest at a specified rate.
For example, if a company issues a bond with a face value of Rs 1,000, maturing in 10 years with an 8% annual coupon rate, the company would pay you 8% of your invested amount each year. At maturity, you would get Rs 80 plus your principal investment of Rs 1,000.
Types of Corporate Bonds
- Fixed-Rate Bonds
○ The issuer promises to pay a fixed coupon rate till maturity. For example, a fixed-rate bond issued in 2016 with a coupon rate of 9% would mature in 2026.
- Zero-Coupon Bonds
○ These bonds do not offer regular interest payments. Instead, they are issued at a discount to their face value and redeemed at face value at maturity. For example, if a bond with a face value of Rs 1,000 is sold for Rs 750, it would be redeemed at Rs 1,000 at maturity. The investor earns Rs 250 from the difference between the face value and the discounted purchase price.
- Tax-Exempt Bonds
○ Issued to fund specific projects, these bonds are exempt from tax under Section 10 of the Income Tax Act of 1961. They are attractive to individuals in higher tax brackets.
- Callable Bonds
○ These bonds can be redeemed by the issuer before maturity, often at a higher interest rate than non-callable bonds. For example, a callable bond issued in February 2019 with a coupon rate of 10.24% can be redeemed before maturity, with the call date set for February 2024.
- Convertible Bonds
○ These bonds can be converted into equity shares at maturity. For example, a company might issue convertible bonds that are converted into shares based on the share value at maturity.
- Secured vs Unsecured Bonds
○ Secured bonds are backed by assets, while unsecured bonds are not. In the event of default, secured bondholders can claim the company’s assets. Unsecured bonds are riskier but offer higher interest rates. It is essential to evaluate the creditworthiness of the issuer when considering unsecured bonds.
Ratings of Corporate Bonds
Credit Rating Agencies Rate the Bonds. Bond Ratings Are:
- AAA: High safety and low credit risk
- AA: Safe investment with low credit risk
- A: Safe with low credit risk
- BBB: Moderate credit risk and moderate safety
- BB: Moderate default risk
- B: High risk of default
- C: Very high risk of default
- D: Default or imminent default
How to Purchase Corporate Bonds
- New Issue Bonds
○ Companies issue these bonds when they need funds, and they are offered to the public first.
- Secondary Market
○ Bonds can be bought through stock exchanges like the National Stock Exchange and Bombay Stock Exchange if you missed the initial offer.
- Corporate Bond Funds
○ These funds invest at least 80% of their corpus into AAA-rated debt instruments, thus suitable for low-risk investors.
Why Does the Coupon Rate Change in the Secondary Market?
The coupon rate is the interest rate you get on a bond, but the yield changes with the bond’s price in the secondary market.
For example, a bond of face value of Rs 1,000 and a 10% coupon rate pays Rs 100 annually. If the bond’s market price is Rs 1,200, the yield drops to 8.33% (100/1200 multiplied by 100). If the bond’s price is Rs 800, the yield increases to 12.5% (100/800 multiplied by 100)—yield changes with the bond’s purchase price.
Advantages of Corporate Bonds
- High Yields
○ Corporate bonds offer higher returns than bank fixed deposits or government bonds. For example, a corporate bond may offer an 8.8% interest rate compared to 5.5% for fixed deposits and 6% for government bonds.
- Low Risk
○ Check the credit rating before investing. AAA+ or AAA-rated bonds are generally safer and have lower default risk.
- Liquidity
○ Corporate bonds are listed on stock exchanges, thus making them easy to buy and sell.
- Shorter Duration
○ Corporate bonds have a shorter duration than government securities, typically 60 to 120 months.
Disadvantages of Corporate Bonds
- Credit Risk
○ There is a risk of default if the issuer goes bankrupt. Always opt for AAA-rated and secured bonds to minimise this risk.
- Costly
○ Bonds have a minimum investment requirement. For example, some bonds require a minimum investment of Rs 10,000.
Tax on Bonds
Interest Earned on Corporate Bonds is Taxed as Income. For Listed Bonds:
- Short-Term Capital Gains (STCG): If sold within one year, taxed as per your income tax slab.
- Long-Term Capital Gains: If sold after one year, taxed at 10% without indexation.
For Unlisted Bonds:
- Short-Term Capital Gains: If sold within three years, taxed as per your income tax slab.
- Long-Term Capital Gains: If sold after three years, taxed at 20% without indexation.
For Corporate Bond Funds:
- Short-Term Capital Gains: If sold within three years, taxed as per your income tax slab.
- Long-Term Capital Gains: If sold after three years, taxed at 20%.
Are Corporate Bonds for You?
Corporate bonds can be suitable investments for those who want higher returns with lower risk than stocks or volatile investments. For those nearing retirement or a financial milestone, corporate bonds can offer stable returns and capital preservation. In your 20s, investing a portion of your portfolio in bonds can help diversify and reduce stock volatility. Always check the bond’s credit rating before investing and opt for AAA+ or AAA-rated bonds. A Demat account is required to trade corporate bonds.