Corporate bond mutual funds offer an excellent investment opportunity for people looking to invest in mutual funds. They also provide interest income, safeguard your portfolio against stock volatility, and enable you to diversify your overall holdings. But are these funds safe to invest in?
Corporate bond mutual funds are safe, low-risk, high-income investment vehicles. But while they ensure capital protection, these funds are not 100% safe as they are prone to market risks, fund managers can make a wrong call, and companies can default on payments.
In this article, you will find detailed information on corporate bond mutual funds that will help answer this question. In addition, you will also discover whether these funds pose any risks and, if so, how to avoid them.
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What Are Corporate Bond Mutual Funds?
Corporate bond mutual funds are debt mutual fund schemes that pool together investor funds to invest in corporate bonds. Companies issue corporate bonds to enable them to fund short-term expenses, growth, and expansion.
The bond funds invest in a wide range of debt papers issued by these firms, including non-convertible debentures and commercial papers. Each debt paper sports its own risk profile and maturity period, and both affect the overall value of the corporate bond mutual fund.
Many companies prefer using these debt funds to raise capital for their needs as an alternative to bank loans since they cost much less. The firms commit to repaying investors’ money in full, plus interest, over a specific period, which is usually 1 to 4 years.
In general, corporate bond mutual funds invest over 80% of their finances in highly rated corporate bonds.
Here are some of their key features:
- You can invest in them through a broker or via a mutual fund.
- They pay higher interest rates than banks or money market funds.
- They have a lower credit risk compared to other debt funds that invest in lower-rated securities.
- They provide investors with an affordable opportunity to invest in corporate bonds, which require a considerable capital outlay when investing directly.
- They enable you to diversify your portfolio because you automatically invest in multiple bonds.
- Most funds make monthly rather than semi-annual interest payments providing easy cash flow for income-seeking investors.
How Do Corporate Bond Mutual Funds Work?
Corporate bond mutual funds work by buying corporate debt papers whose prices move based on demand, and the transactions take place at the stock exchange. When a corporate bond in a mutual fund increases in value, the fund’s value increases, and investors profit.
When you purchase a corporate bond, you loan money to the issuing firm. The company repays the principal amount upon reaching the maturity date. You also receive interest on the principal at a fixed rate (coupon rate) once or twice every year.
To invest in corporate bond mutual funds, you have a choice between two broad categories:
- Corporate bonds that invest in high-rated companies. Companies that boast a high credit rating have low chances of defaulting, while relatively lower ratings have a higher risk factor.
- Corporate bonds that invest in lower-rated companies. These funds are riskier to invest in since the chances of default are high. The volatility witnessed here is higher during troubled economic times and periods of rating adjustments. The thing is, a default here can affect your returns and erode capital too.
Are Corporate Bond Mutual Funds Safe Investments?
Corporate bond mutual funds are safe investments and suitable for investors looking for fixed high returns. As debt instruments that ensure capital protection, corporate bond mutual funds contain a low sensitivity to risk.
Because corporate bond mutual funds mainly invest in premium quality instruments, their credit risk is comparatively lower than that of similar debt funds that invest in lower-rated instruments.
These funds withstand financial market upheavals relatively well. As a result, corporate bond mutual funds deliver steady returns, unlike other debt securities, and are highly liquid. Furthermore, since they carry higher credit risk, they tend to offer higher interest rates.
Still, while corporate bonds make relatively safe investments, their safety level depends on the investment strategies employed by the fund managers. They also face certain risks as we shall see next.
Potential Risks of Investing in Corporate Bond Mutual Funds
Corporate bond mutual funds are not as risky as equity-focused mutual funds, but they still carry some level of risk. Below are some of the potential dangers, plus tips on how to avoid them:
Market Risks
Market risk is also known as interest rate risk. Depending on market changes, bond values can change before reaching maturity. For instance, a rise in interest rates results in an increase in the bond’s value.
With corporate bond mutual funds, the funds’ returns are directly proportional to the fund portfolio’s risk rating. This means that funds invested in high-rated bonds will be less volatile to market risks and provide more stable returns.
One way to avoid market risk is to make sure you hold corporate bonds until maturity. If you exit early and the bonds have declined in value, you risk losing money on your investment.
The Fund Could Underperform
If the fund manager fails to use appropriate investor strategies or manage the fund well, the corporate bond mutual fund could deliver lackluster returns. But if the manager picks high-rated company bonds only, the risk of the companies defaulting is considerably less.
Therefore, as an investor, you need to maintain routine check-ups on your portfolio holding and plan for an exit if not satisfied with the results.
That said, firms having a low credit rating tend to offer higher coupon values to attract mutual funds. A skilled portfolio manager could opt to invest in such funds during favorable market conditions but withdraw from the same when fluctuations become imminent.
Credit Risk
Credit risk, or default risk, occurs when the issuing corporation defaults on repaying outstanding bonds or making interest payments owing to a lack of funds. This could translate to the corporate bond mutual fund experiencing partial or total investment loss.
You could also experience a call risk. This happens when the bond issuer calls the bond because of falling interest rates.
How to Invest Safely with Corporate Bond Mutual Funds?
How do you ensure your investment remains safe when investing in corporate bond mutual funds? Try the following:
- Choose high-quality corporate bond funds. While corporate bond mutual funds remain mostly safe, this is not always the case, as noted earlier. Thus, since long-term debt funds are often risky because of fluctuating interest rates, it’s advisable to choose corporate bond funds that invest in high-quality debt instruments.
- Consider credit risk and duration risk. Longer-term bonds provide higher interest rates, but they also come with higher stakes. When interest rates are on the rise, the longer the term, the higher the risk of capital losses. This is because a sharp rise in interest rates might erode the fund’s value. You, therefore, want to consider both credit and duration risk when choosing the most appropriate corporate bond mutual fund.
- Consider staggered investments. To mitigate duration risk or potential capital losses, consider making staggered investments into your corporate bond mutual fund. This is similar to an equity fund’s SIP. You could also choose to invest only in government securities to help lower your credit risk.
On their part, corporate bond funds combat volatility by investing in scrips and adopting a 1-4 year investment horizon. Therefore, for best results, it’s better to stay invested for over 2 years.
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Conclusion
Corporate bond mutual funds deliver steady returns and minimal downside risk. They are ideal for investors looking for fixed, regular incomes from an investment much safer than equity. But while returns here are relatively predictable, there are no guarantees of assured returns.
Hence, the best thing is to adopt a long-term investment horizon when investing in corporate bond mutual funds so as to benefit from capital appreciation.
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