How to choose corporate bonds
Corporate bonds are an alternative to bank FDs to earn regular income, but you need to analyse the company's financial strength before investing in their bonds
Most conservative investors keep looking for alternatives to bank savings accounts and fixed deposits. While government securities are a safe and stable alternative to these investments (read this article for information on G-Sec ETFs), investors can also look at corporate bonds. Here are the details you need.
What are corporate bonds?
Companies need capital for conducting their businesses. There are several ways to get money. One of them is by issuing corporate bonds to investors. Corporate bonds are debt securities issued by private and public corporations. Since bank loans are expensive, companies find this an easy way of raising low cost capital for their business.
When you buy a corporate bond, you lend money to the company that issued the bond. For this, the company promises to pay interest and return the money on a specified maturity date. So, when you buy a bond, the company is borrowing money from you. It will pay interest to you on the investment and will repay the principal after the maturity of the investment. While you will look at the interest rate if you are buying bonds from the company, when you are buying bonds from the secondary market, you will need to look at the yields of the bonds.
What are bond yields?
Yield helps you measure the return of different bonds. Yields are not fixed because this is not the interest rate on the bond. Yields change with the price movements of a bond and interest rates. Bond prices are inversely proportional to the yields.
Corporate bond yields tend to rise in value when bond prices fall, and they fall when bond prices rise. The longer the maturity of the bond, the greater will be the price volatility. For instance, if you buy a bond and sell it after a year, you will receive a lower price on the bond if the interest rates are rising. This is because your bond is paying a lower interest rate. There is present yield and yield to maturity (YTD). Present yield is based on the market price of the bond. If the market price of the bond is more or less than the face value of the bond, the present yield will be different. For instance, if you buy a bond with a face value of Rs. 100 and it provides interest of 7%. If the price of the bond is Rs. 94.5, your present yield will be 7.4% (Rs. 100 x .07/Rs.94.5).
YTM is the yield that you will receive if you hold a bond until maturity. It helps you compare bonds that have different maturities and coupons. YTM will include all the interest payments and the capital gains on the bond.
However, if you hold the bond till maturity, you don’t need to worry about yields. By holding a bond until maturity, these price fluctuations known as interest-rate risk, or market risk will not affect you because you will receive the principal at maturity.
What are the advantages of corporate bonds?
The main benefit of investing in corporate bonds is their higher yields. The yields are much higher than that of government bonds. Another benefit is the income from these investments. Corporate bonds provide interest on the bonds. These are known as coupon payments. You can receive the money in your bank account.
Corporate bonds are provided with credit ratings. These ratings enable you to evaluate corporate bonds. The higher the rating of the bonds, the safer it is to invest in them. The most important benefit of investing in corporate bonds is that you can sell them easily in the secondary market. There are several investors in the corporate bond market that include mutual fund houses. There are always people buying and selling corporate bonds. So, you can sell your bonds in the market anytime.
How to invest in corporate bonds?
Investors can use their demat account for purchasing bonds. The help of a broker will be needed for this. This is because picking a corporate bond is tough for a novice investor. Wealthzi.com can guide you on investing (Click here to learn more).
You can invest in corporate bonds through mutual funds. Corporate bond funds provide you with the benefit of investing in corporate bonds along with diversification and professional management. You can take advantage of taxation if you stay invested for more than three years. Long Term Capital Gains (LTCG) of these funds are taxed at 20% with indexation benefit.
Who should invest in corporate bonds?
Corporate bonds are ideal for low to moderate risk investors who want higher returns on their fixed income investments. However, one should purchase corporate bonds only if they have the knowledge to analyse the company’s fundamentals. Otherwise, it is best to invest through mutual funds.