Corporate Bonds: Types, Interest Rates, Taxation & More

Bonds are debt instruments preferred by investors who are risk-averse and would like to earn stable and regular income through their investments. Corporate bonds are issued by private corporations to raise funds for business expansion or launching new products. Another way of raising funds for these corporations is through equity shares.

In this blog, the focus will be on corporate bonds, their types, interest rates, advantages, and other details.

What is a Corporate Bond?

Corporate bonds are debt instruments offered by private companies to raise funds for various purposes. These bonds come with specific interest rates and tenures. Investors or lenders invest in these bonds in exchange for periodic interest payments at the decided interest rate.

At the end of the maturity of the bond, the company pays the lender or the bondholder the principal or face value of the bond.

Corporate bonds in India have a higher rate of interest when compared to the government. This is due to the risk of repayment which depends on the company's profitability.

Types of Corporate Bonds

Indian corporate bonds are classified into different categories depending on their interest payments, characteristics, and security covers:

1.Zero-coupon Bonds

As the name suggests, zero coupon bonds do not offer any coupon or interest payment to the investor. Instead, investors get to purchase them at a discounted value. The benefit for the investors is the difference between the discounted and face value at the time of redemption.

2.Convertible Bonds

Convertible bonds come with the condition of getting converted into equity shares under certain trigger events at a specific time. The conversion ratio is pre-determined by the issuer and bondholders are informed about the same.

At the time of conversion, the bonds take the anticipated stock price into account. Due to this condition of conversion, these bonds come with slightly lower rates of interest than other types of corporate bonds.

Convertible bonds can further be classified into two types:

• Fully Convertible: These bonds can be wholly converted into stocks as per the pre-decided conversion rate.
• Partially Convertible: A certain percentage of these bonds can be converted into equity shares.

 3. Floating Rate Bonds

These corporate bonds pay interest rates as per an external market benchmark. These rates are linked to a particular rate are reset at a periodic interval and are updated as per the changes.

4.Fixed-Rate Bonds

Fixed-rate bonds pay a fixed interest rate to bondholders at regular intervals. Hence, by investing in these bonds investors get a fixed and stable source of income.

5.Investment Grade Bonds

Based on the credit ratings, corporate bonds can be classified into two categories – investment grade and non-investment grade. Among these, bonds with credit ratings of AAA and BBB are known as investment-grade bonds.

6.Junk Corporate Bonds

Junk corporate bonds are non-investment grade bonds. These are all other bonds except the ones with AAA and BBB ratings which are investment-grade bonds.

Corporate Bonds Interest Rates in India

Refer to the following table for some highly rated corporate bonds’ interest rates and other details. The table is arranged in the descending order of the bonds' yields.

*Data Valid as of October 29 2023

How to Buy Corporate Bonds?

In the primary market, corporate bonds and deposits can be purchased through brokers, bankers or bond dealers. Some bonds can also be purchased over the counter. Brokers provide basic information such as face value, coupon rate, credit rating, maturity, allocation and repayment dates to facilitate informed decision-making.

Advantages of Investing in Corporate Bonds in India

Corporate bonds offer the following advantages to the investors:

1. Tax efficiency: Corporate bonds, considered long-term investments (over three years), offer tax benefits. Taxation is 20% with indexation benefits, which is particularly advantageous for investors in the highest tax bracket.
2. Yields: Corporate bond funds offer higher returns but carry significant risks compared to government bonds. The greater the risk, the greater the potential returns. Additionally, these bonds offer greater growth potential and provide investors with regular coupon payments.
3. Liquidity: Most corporate bonds are tradable in the secondary market, allowing investors to buy or sell them after they are issued. This flexibility allows investors to sell when bond prices rise or buy when prices fall.
4. Holding and Coupon Structure: Corporate bonds have different maturities (long-term, medium-term, short-term and permanent) and offer different coupon structures (fixed rate, floating rate and zero coupon). Investors can choose the options that best suit their preferences.
5. Instant Rewards: These bonds have a relatively quick return due to the shorter duration of the investment.

Disadvantages of Investing Corporate Bonds

Now that you know the advantages a corporate bond can offer to its investors, you should be aware of the disadvantages as well. This will help you make an informed decision:

1. Lower Returns Compared to Stocks: While corporate bonds offer stability, their long-term returns may not match stocks. Stocks have the potential for higher returns over the same investment period, making them a more lucrative option for long-term investments.
2. Certain Payment: When you invest in a fixed-rate bond, the interest rate is predetermined at the time of issue, ensuring predictable future payments. In contrast, floating-rate bonds offer fluctuating payments within set terms, unlike dividend stocks, which can increase payouts over time.
3. Vulnerability to Changes in Interest Rates: Bond values ​​are affected by fluctuations in interest rates. If rates rise, the attractiveness of bonds decreases, leading to a decrease in the value of bonds. This can present problems when selling bonds in the secondary market.
4. Risk of Returns: Corporate bonds yield higher returns than government bonds due to increased risk. Unlike governments, companies can default on payments. In the event of default, bondholders have priority, yet there is a risk that they will receive minimal compensation.

Risks Associated with Corporate Bonds

There are some default risks associated with investing in corporate bonds:

1. Credit or Default Risk: Corporate bonds are rated by credit agencies, which indicates their risk of default. Lower-rated bonds offer higher interest rates but carry a higher risk of default. Higher-rated bonds are safer, but any bond, regardless of rating, can fail. Even highly rated bonds are not immune to default risks.
2. Interest Rate Risk: Corporate bonds are long-term debt investments which are sensitive to fluctuations in market interest rates. When interest rates rise, bond values ​​fall due to increased opportunity costs for investors. This decline in bond prices offsets higher market interest rates.
3. Inflation Risk: Bondholders receive fixed or variable returns. However, if inflation outpaces income growth, the purchasing power of these people will decrease. Inflation distorts the real rate of return, which can result in a negative rate. Factoring in inflation is crucial because it reveals the true impact on purchasing power.
4. Liquidity Risk: Unlike government bonds, corporate bonds have limited buyers and sellers, resulting in a thin market. Low demand can cause price volatility and affect bondholders' overall returns when sold. The sale of corporate bonds could bring in lower prices than expected due to a lack of buyers.

Who Should Invest in Corporate Bonds?

Corporate bond are a low-risk investment options that provide capital protection for risk-averse investors. These typically have a maturity of 10 to 30 years therefore investors planning to save money for meeting their long term needs might find them suitable.

Corporate bonds offer higher interest rates due to increased credit risk. Government bonds are more stable and have a minimal risk of default. The risk associated with corporate bonds depends on the investment strategies, with higher-rated companies having a lower probability of default, while lower-rated companies are riskier.

Taxation on Corporate Bonds in India

Corporate bond interest is taxed as per your income tax slab, while capital gains on listed bonds are taxed at 10% for long-term holdings (over 36 months) and at the low investor income tax rate for short-term holdings (less than 36 months). Long-term gains on unlisted bonds (over 12 months) are taxed at 20% with the benefit of indexation and short-term gains are taxed at the investor's income tax rate.

Conclusion

There are various types of corporate bonds available in India. To find the ideal bond for your financial goals, compare them based on face value, coupon rate and credit score. Corporate bonds offer advantages such as high returns, low risks and diversification. Check credit ratings for high return and low risk and make a smart choice for portfolio diversification. Also, make sure you have a demat account.