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Why corporate bond funds are better alternatives

corporate bond

Investors have shown renewed faith in corporate bond funds in recent times. These funds invest at least 80 per cent of their portfolios in AAA and AA+ rated bonds. As the markets turn bumpy and credit risk is shunned, investors flocked for relatively less risky avenues of investments. 


Corporate bond funds have seen sustained inflows since April 1, 2020, to the tune of Rs 30,646 crore. In July it was one of the most sought after category of mutual funds, with investments of Rs 11,910 crore, as per data released by the Association of Mutual Funds of India.
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According to Value Research, corporate bond funds have delivered 10.04 per cent and 7.31 per cent returns over the past one and three-year periods. Credit risk funds, as a category, lost 0.91 per cent over the past one year and gave 0.96 per cent returns in three years. The best of debt schemes lot, Banking & PSU debt funds (BPSU funds), outperformed with 10.23 per cent and 8.3 per cent returns, respectively over same timeframe.

Are past performances repeatable?

Though past returns look good, do not get carried away by this performance. Corporate bond and BPSU funds did well due to a combination of factors. Interest rates decreased steadily and bond markets rallied smartly. Investors preferred to shift from low-rated to high-rated bonds. Funds with good quality bonds reported healthy performances. The Reserve bank of India has aggressively cut interest rates since June 2019 by 200 basis points – of which 115 basis points were reduced since March 2020.
Though corporate bond funds are attractive, investors must taper down their future return expectations. Portfolios focused on AAA-rated bonds offer yields of just over 5 per cent – a tad higher than comparable instruments issued by banks and public sector undertakings. The category average return stands at 5.44 per cent. And the scope for further capital appreciation on the back of falling interest rates looks limited. “The RBI has already cut rates significantly. If inflation remains under control, expect 25 to 50 basis point more cut in policy rates in the near term,” says Dwijendra Srivastava, Chief Investment Officer-Fixed Income, Sundaram Asset Management Company.


Getting the tenure right

Though interest rates are not expected to go up in the near term, most fund managers are investing in corporate bonds maturing in 2-4 years, to contain the interest rate risk. “If an investor has a view that the interest rates will increase after two years, it makes sense to invest now in good quality portfolios with around three years’ modified duration,” says Srivastava.
Despite the possibility of earning healthy risk-adjusted returns, investors should not blindly chase returns.  Joydeep Sen, founder of wiseinvestor.in says, “Investors must check the portfolios of corporate bond funds before investing, even though 80% or more is in AAA or AA+ rated instruments.” He recommends investing in schemes that get into companies with AAA rating and mature in three to four years.
“Some corporate bond funds are betting on long-term bonds to generate excess returns in a falling interest regime. Hence, investors must check the modified duration of the scheme,” says Sayalee Khandke, Manager-Research, Investica.
In a falling interest rate regime, portfolios with high modified duration work better. For example, L&T Triple Ace Bond, which delivered the highest one-year return of 12.84 per cent in its category, has a modified duration of 5.71 years compared to 3.73 years for the category on an average.
However, as there may be limited scope for further interest rate cut, it makes sense to stick to portfolios with relatively lower – around three years’ – modified duration. Also avoid portfolios that invest in AA or lower rated papers in search of higher yields. The strategy can backfire in the case of defaults or downgrades.
“Instead of investing in a low-rated company fixed deposit for a higher yield, it makes sense to invest in a corporate bond fund with a minimum three-year time frame,” says Khandke. Capital gains earned on units held for more than three years are taxed at 20 per cent after indexation. But interest from company fixed deposits are taxed at your slab.