Is investing in corporate bonds worth the risk?

Corporate bonds are debt instruments issued by public sector or private companies.

With volatile equity markets, many investors are enquiring about corporate bonds due to the attractive 9-14 percent returns they offer. Several online platforms offer a variety of such bonds, which investors are lapping up as they feel that good taxable returns are better than volatile equities.

But can corporate bonds really be compared with stocks?

These are debt instruments issued by public or private sector companies. The issuers are typically non-banking financial companies (NBFCs), which raise funds to lend to their clients.

The risk in corporate bonds and equities is completely different. Also, most corporate bonds mature in one-three years, whereas equities are meant for the long term, at least seven years.

The risk in corporate bonds

Default is the biggest risk in corporate bonds, which means that the bond issuer may not return the principal or pay interest. Many  bonds listed on online platforms are A to BBB- rated, with very low collateral. Compare this to mutual funds, which are mandated to invest in bonds rated A and above. A majority of mutual fund bond holdings are AAA or AA rated.

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From the information available on bond platforms, you can see that many borrowers have moderate asset quality and / or profitability, asset-liability mismatches, or are new companies whose loan portfolios haven’t seen different business cycles. Investors are going by the name of the company without really evaluating its financial performance. Remember, the platform cannot help in case of default. And there is no deposit insurance guarantee cover (DGIC) available on bonds, unlike fixed deposits.

Though a BBB bond rating represents moderate credit risk, the actual risk on such bonds can be dangerously high. The reason an issuer is rated so low is due to concerns of cash flows and profitability, which can lead to delays in interest payments or defaults.

While some bonds show a collateral cover of 1-1.15 X and some also classify as senior debt, the collateral provided is pretty low for bonds rated below A. Based on past instances, it is very difficult to liquidate the security in case of default. Even if some money can be recovered, financial institutions have the first right on it and retail investors are last in the priority list.

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These bonds come with high liquidity risk, i.e.,  the inability to sell the bond before maturity. Because a lumpsum is being invested in a bond, there is also concentration risk. Even if one bond delays or defaults, it will have an impact on the investor’s portfolio.

And even if the investor agrees to take on all the risk, the bond yields are grossly inadequate for the level of risk taken. There is at least a 200-300 basis point (bps) gap between the yields shown on the platforms and the actual returns investors get. Lastly, the bonds will need to be held till maturity and  taxed per one's slab.

What is the alternative?

Investors wanting higher returns from debt investments can consider credit risk funds. These invest 80-85 percent of their portfolio in AAA & AA rated bonds, and the balance in A rated bonds. While the taxation on credit risk funds and corporate bonds is the same and credit risk fund returns are lower, they provide much better risk management, diversification, and peace of mind.

Risk is the silent partner in every investment. It is wise to know it well before committing capital.

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The author is a financial educator, founder director of Finsafe India Pvt. Ltd and co-founder of Womantra

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.