What is Corporate Bond Fund - Features, Returns and Taxation

Published On: 24-Jun-2020

Corporate Bond Fund is an open-ended debt scheme predominantly investing in AA+ and above rated corporate bonds. Minimum investment in corporate bonds – 80% of total assets (only in AA+ and above rated corporate bonds. Corporate Bonds are one of the predominant sources of funds for the companies willing to borrow from the market, apart from the borrowings from banks and financial institutions. 

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Corporate Bond funds are the third most popular category amongst the debt funds, after liquid funds and short-duration funds as on 31st May April 2020 occupying around 8% share across the overall AUM (Assets Under Management) of open-ended debt schemes with AUM of Rs. 0.91 lakh crores 

Source: Association of Mutual Funds in India - AMFI.

Here are the salient features of Corporate Bond Funds:

Investing in AAA-rated Companies

The corporate bond fund carries the investment mandate to invest a predominant portion of the portfolio in the bonds of AAA-rated companies. Since AAA credit rating denotes the highest degree of safety for the investors, Corporate Bond funds inherently carry lower credit risk. 

Average Maturity of the Portfolio

There is no specific duration that such funds intend to aim at. The fund may decide on the optimal fund duration to mitigate the interest rate risk depending upon the future outlook. If the interest rates are expected to decrease over time, the duration of the portfolio may be increased. On the other hand, the fund may lower the fund duration if the interest rates are expected to increase. This is due to the negative correlation between interest rates and bond valuation. 

Liquidity

Since there is a high degree of safety for the investors, AAA-rated bonds tend to be highly traded in the secondary markets. As per the CRISIL AMFI Mutual Fund Factbook 2018, market trades in AAA-rated securities accounted for more than half of the secondary market trades in FY 2017-18. Given the large trading volumes for AAA-rated securities, such funds tend to be significantly insulated from the liquidity risk for the investors. 

Mutual Fund Returns

The primary sources of returns of Corporate Bond funds are through accrual income and appreciation due to favourable interest rate movements. The accrual income may be generally gauged through the yield of the bonds in the fund portfolio. Markets price the bond yields by adding the credit spreads to the risk-free G-Secs return for a similar tenor. 

Credit spreads denote the credit risk premium for the issuer company. With a minimum of 80% investment in the highest-rated companies, the return expectations should be reasonable due to the lower credit risk perceived for such funds. 

Taxation of Corporate Bond Funds

As per the Income Tax Act, 1961, the returns from mutual funds are taxed at the time of receipt of dividends or redemption of mutual fund schemes. Dividend income is taxed at the regular tax rates as applicable to the investor. Further, if the total dividend paid by the mutual fund house to investor exceeds Rs 5,000 in a year, TDS at the rate of 7.50% (reduced rate by the Govt. because of Covid-19 measures only till 31st March 2021) is deducted on such dividend income.

The appreciation in mutual fund units is taxable under the head ‘Income from Capital Gains’. Corporate bond funds will be classified as non-equity oriented mutual funds for tax purposes, considering at least 80% portfolio in debt securities. The gains from such funds are categorized as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) based on the period of holding of mutual fund units. 

If the holding period is less than 36 months, the returns are taxed as STCG at the regular tax rates applicable to the investor. However, in case of a holding period of 36 months or more, the gains are classified as LTCG and taxed at 20% (plus applicable Cess and surcharge) with indexation benefit. The indexation benefit effectively lowers the overall tax incidence for the investors from such returns.

Should you invest in Corporate Bond Funds?

Investors who are looking to generate reasonable tax-efficient returns for their debt portfolio, albeit with lower risks, may consider investing in Corporate Bond Funds.

Note: The tax provisions, as mentioned in the article, are for illustrative purposes only, and are updated as per the Union Budget 2020 passed by the Parliament and the Covid-19 related measures announced by the Govt. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.