What Are Corporate Bond Funds And How Do They Work?
Corporate Bond Funds, also called “Credit Opportunities Funds”, have been gaining in popularity over the past few months. Per data from Mutual Fund Research portal Valueresearch, the cumulative assets under management for the 26 Corporate Bond funds stand at an impressive 96,000 crore rupees (0.96 trillion) as on date. That’s close to 5% of the total industry AUM today. HDFC Corporate Debt Opportunities Fund and Birla Sun Life Medium Term Plan lead the pack in terms of assets, with 12,107 crores and 10,663 crores respectively. As a category, these funds have delivered 10.22% returns in the past year, with Baroda Pioneer Credit Opportunities Fund- Plan B Direct logging the best 1-year performance, at 12.62%.
Where do Corporate Bond Funds invest?
As the name suggests, Corporate Bond Funds invest into fixed income instruments issued by companies. These include bonds, debentures, commercial papers and structured obligations – each of which carries a unique risk profile and maturity. Corporate Bond Funds sometimes do take very small exposures to government securities as well, but usually only when no suitable opportunities in the credit space are available. On an average, Corporate Bond Funds have a 5.22% allocation to sovereign fixed income as on date.
How do they make returns?
Corporate Bond Funds aim to make returns in two ways. First, and easier to understand, is by accruing the coupon payments arising from the securities held by it. The second is by way of benefiting from a compression in yield spreads. In doing so, Corporate Bond Funds take on a deliberate credit risk by investing into lower rated securities, that have the potential to be upgraded in the future.
The mechanism of return generation through yield spread can best be understood with an example. Say, a AA rated bond with a coupon of 8% per annum trades at Rs. 998 with one year remaining to its maturity. In this case, the “yield to maturity” of the bond is approximately 10.02%. For illustration’s sake, assume that the yield commanded by higher rated AAA bonds is closer to 8%, and the AA rated bond purchased by the Fund Manager goes through an upgrade from AA to AAA. The price of the bond will go up from Rs. 998 to Rs. 1000, to reflect its newly deserved YTM. This would result in a capital gain of Rs. 2.
What are the risks involved?
There’s always the possibility of a bond issuer defaulting on its obligations, and this default risk is higher for lower rated securities, and goes up exponentially with increasing maturities. For instance, if history is to serve as a reference point, a CRISIL “A” rated bond with 1-year residual maturity has a 0.56% chance of defaulting, whereas a CRISIL “A” rated bond with a 3-year residual maturity has a 4.79% chance of defaulting. Considering that Corporate Bond Funds typically allocate at least half their portfolios to bonds that are ranked AA or lower, there’s always the risk of some of its portfolio bonds defaulting, resulting in a drag on portfolio returns.
Advice to Investors
Corporate Bond Funds are best suited for seasoned debt fund investors who understand the precise risks at play. A large number of defaults within a fund’s portfolio can lead to a serious drag on returns. If you decide to invest into them, don’t be swayed by past returns, but rather stick with the offerings of large AMC’s (preferably, the top 5) only. New investors are advised to stick to highly rated, short term debt funds with lower credit risk instead.
