Corporate bonds are debt instruments issued by a corporation(both public and private companies can issue corporate bonds), the holder of which receives interest from the corporation periodically for a fixed period of time and gets back the principal along with the interest due at the end of the maturity period. In India, the terms ‘corporate bonds’ and ‘debentures’ are interchangeably used. Though different countries have different interpretations of both the terms ‘corporate bonds’ and ‘debentures’, India’s Companies Act (Section 2(12)) identifies both as same.
How to invest in corporate bonds?
The company which is planning to raise funds through corporate bonds will offer a public issue or a private placement. A public issue means an offer will be made to the public in general to subscribe to the bonds. In a public issue, the company has to issue a prospectus before issuing the bonds. After the public issue, these bonds are listed on a recognized stock exchange in India. Hence such types of bonds are called listed bonds. A private placement is usually made to institutional investors and not to retail investors.
Benefits of investing in corporate bonds
Investment in corporate bonds generates fixed income periodically; corporate bonds may be an ideal investment for the people who want a fixed income. It normally offers a higher rate of interest as compared to fixed deposits or postal savings or similar investments. If bonds are listed, it can be sold in the secondary market before its maturity. While a bond is usually not designed for capital appreciation; a listed bond may also earn capital appreciation i.e. Bond can be sold at a price higher than the cost price in the market.
Risks involved in investing in corporate bonds
Credit Risk: Credit risk is the risk, an investor face when company in which investment is done defaults on the interest payment or does not pay back principal. This risk could be mitigated if you will analyze the capacity of the company to meet its financial obligations. If the company is in good financial position then chance to default is also less.
Prepayment Risk: when the bonds contain the clause that allows the issuer to redeem the bonds before the due date, then the prepayment risk could be faced by investor in the future. You could mitigate this risk only by carefully reading the prospectus whether such an option is attached to your bond. If such an option exists, you can invest only if you are ready to deal with the prepayment risk.
Interest rate risk: When you invest in a listed bond, you have to face the risk of interest rates go up and down and the resultant change in the market price of the bonds. In case the interest rates go up, the market price of your bond will go down and if you plan to sell your bonds at that time, you may end up with less money than what you paid when you bought it. You may hedge this risk by investing in derivative instruments such as interest rate future or swaps.
Liquidity risk: If you want to sell your bonds before its maturity date, you may face the risk of not finding a buyer easily for your bonds. This is called liquidity risk. You could mitigate this risk by checking whether there are enough volumes in the market to reduce the liquidity risk. Higher the volume less is the liquidity risk attached with the bonds.