Portfolio diversification is a technique of spreading investments across various asset classes with an aim to reduce overall risk. As different asset classes perform differently in any given market cycle a mix of all asset classes in a portfolio can provide better risk adjusted returns to the investors. When it comes to planning for their financial goals, investors primarily look at investing in equity markets. However, debt markets being relatively stable as compared to equity markets, can play an important role in building a more stable portfolio for investors.
One of the most convenient ways of investing in a debt markets is through Mutual Funds. Mutual Funds offer different types of debt funds that invest in a range of debt instruments having varied maturity. One such type of fund is Corporate Bond Fund, which predominantly invests in corporate bonds.
Corporate bonds are debt securities issued by firm/company in order to raise money to carry out operational activities/fulfill working capital requirements. Raising money through corporate bonds is just like taking a loan from bank where bank is the lender and a person/entity is a borrower. Borrower pays interest to the bank on the borrowed sum on a periodical basis. In case of corporate bonds, company borrows money from the individuals or financial institutions such as mutual funds instead of a bank. In case of Mutual Funds, the company is a borrower and the mutual fund scheme is the lender. Companies issue such bonds for a specified tenure and at a fixed interest rate which is received by scheme in the form of coupons and the final amount is received at the time of maturity.
Corporate bonds have different credit rating that reflects the risk associated with each bond. To highlight the level of risk involved, bonds are rated by a rating agency from AAA to D (Crisil rating agency). While AAA represents the highest safety and D represents the lowest. These ratings are based on the issuing company’s financial strength, business plans, past track records, etc. Corporate bond funds invest minimum 80% of its assets in the corporate bonds which are rated AA+ or above. As these funds generally hold the investments till maturity, they are less impacted by interest rate volatility. These funds primarily follow accrual strategy and hence the returns are generated from the periodical coupon payments.
Corporate bond funds are more liquid as compared to traditional investment avenues as there is no lock-in. Further, if the investment in debt funds are held for a period of 3 years or more, the long term capital gain is taxed at 20% post indexation which helps in lowering the taxable amount. Indexation is a method by which purchase price of an investment is adjusted for inflation, therefore resulting in lower taxable amount. However, there are certain things to be considered before investing in corporate bond fund. The returns in these funds are market linked and change in interest rate can impact the fund performance depending on the duration of the fund. Further, as the certainty of interest and principal repayment depends on the company’s financial strength, default risk cannot be completely ruled out.
Debt funds such as Corporate Bond Funds can help in reducing the overall portfolio risk as compared to a pure equity portfolio and it should be an essential part of investors portfolio. Investors’ willing to invest in high credit quality papers and having an investment horizon of 3 years and above can consider investing in Corporate Bond Funds.