Investors in debt funds have been a worried lot, given the troubles surrounding the segment over the past couple of years. As flight to safety gains prominence, Banking and PSU bond schemes have been the favourite safe haven for debt fund investors. Even so, corporate bond funds too may be worth investing in. Corporate bond funds, as a category, have Rs 86,292 crore in assets under management as of April 2020.
Debt funds investing in bonds issued by corporates have been around for more than two decades. But, over time, some debt funds invested in instruments with lower credit ratings while chasing higher returns. A small portion of the portfolio being invested in such securities is actually a good strategy. But overloading of credit risk in the portfolio can hurt, if the underlying bonds default on interest or principal repayment.
Market regulator Securities Exchange Board of India (SEBI) tightened the definition of debt fund categories as a part of its reclassification exercise. So, ‘Corporate bond funds’ as a category was carved out separately. These are a relatively safer group of debt funds. Most schemes are open-ended and invest largely in highly rated corporate bonds – at least 80 per cent of the portfolio is parked in AA+ and above securities.
As a category, these funds have delivered 8.8 per cent returns over the past one year, according to Value Research.
How different is the category from Banking & PSU Bond funds?
At a recent webinar, Lakshmi Iyer, CIO-debt, and head-products, Kotak Mahindra Asset Management said that corporate bond, Banking & PSU Debt and short-term funds form the troika of safer investments in debt funds.
But corporate bond funds and Banking & PSU bond schemes are not the same. The latter must invest only bonds issued by entities from the banking sector, and from public sector undertakings (PSUs). Banking & PSU Debt funds can also invest in bonds of a lower credit rating issued by the above-mentioned entities. In the case of corporate bond funds, there is no restriction on the sector, but the regulator has strictly restricted investments in bonds with ratings below AA+ to 20 per cent of the scheme’s corpus. Of course, relatively higher rating doesn’t mean returns are assured or that there wouldn’t be credit events. But such a probability is low.
The COVID-induced lockdown means that corporates are suffering due to loss of business and have low liquidity. Though the RBI has made money available to banks to lend to corporates, the reality is that banks have been hesitant to lend to companies with weak credit ratings. Hence it makes sense for investors to stick to funds that invest in top-rated bonds.
“Investments in corporate bond funds compensate investors well as the prevailing yields on top-rated corporate bonds are approximately 100 basis points more than the government bonds of corresponding maturity,” says Joydeep Sen, founder of wiseinvestor.in.
Factors to consider before investing
Avoid concentrated portfolios to begin with.
Past returns give some idea about the performance of the scheme. But do check the portfolios for the risks taken. If the fund has exposure to papers rated below AA+, then there is added risk involved. For example, Nippon India Prime Debt Fund has 5.5 per cent exposure to ‘A’ rated bonds.
Some funds may take minimal or no risks on the credit side. But they may be taking interest rate risk by investing in long-term government bonds and corporate securities. For example the L&T Triple Ace Bond Fund has a modified duration of 5.36 years, whereas UTI Corporate Bond Fund has a modified duration of 3.73 years as of April 30, 2020. Such funds report good numbers in the falling interest regime such as the one we are in, as the prices of bonds held in the portfolio go up. However, if the tide turns, then these schemes may see muted returns, unless fund managers churn the portfolio appropriately.
Invest in a fund which has relatively low duration and high credit quality if you want to reduce the risk levels. Capital gains earned on investments in corporate bond funds held for more than three years are taxed at 20 per cent after indexation benefit. Otherwise the gains are added to investors’ income and taxed at marginal rate.