What are the Types of Corporate Bonds in India?
Bonds have become one of the most effective financial instruments to offer regular income to the holder without a massive risk of losing the principal amount. Among various asset classes, bonds provide the most systematic investment opportunity to offset the losses of other asset classes. Among bonds, corporate bonds are widely popular among investors. However, as there are different types of corporate bonds, it is important to learn about each one of them.
What are Bonds?
Bonds are loan agreements between an issuer and holder, which details the terms of payment (debt servicing) and maturity. These come with a face value. (principal) to be repaid on maturity and can be issued either at a discount or a premium. Bonds are fixed-tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and depend on various factors such as the issuer's credibility, maturity, and interest rates in the market.
The government or large corporations typically issue bonds for their huge capital needs. These are either publicly traded or over-the-counter. Bonds originally come with fixed coupon rates, which is why these were called fixed income instruments. Nowadays, variable or floating interest rates are also quite common.
What are Corporate Bonds?
Corporate Bonds are debt instruments that a private firm or company issues to raise money from the public. People who invest in corporate bonds are called bondholders and lend money to the company by buying the issued corporate bonds.
When the bondholders invest in the corporate bonds of a company, the company makes a legal commitment to provide regular interest payments on the principal amount based on the corporate bond rates. Furthermore, after maturity, the company has to pay back the principal amount to the bondholders. Corporate bond types offer numerous features but have to fulfil the basic legal obligations such as interest payments (not in the case of zero-coupon bonds) and the repayment of principal.
Corporate Bond Market In India
The Indian corporate bond market, though small in size, has massively impacted the financial market. Since 2008, India has witnessed rising investment inflows mainly due to simplified investment procedures, easier clearing and settlement of trades. Furthermore, the issuance of exotic bonds (masala bonds, green bonds etc.) has also allowed for the growth of the corporate bond market in India.
In FY 2020-21, the primary bond issuance amounted to Rs 7.8 lakh crore while the outstanding corporate debt amounted to Rs 35.1 lakh crore, which was 18.2% of India’s GDP. With the increase in the demand for the corporate bond market in India, Crisil has predicted that the outstanding corporate bond market is expected to double and reach Rs 65.70 lakh crore by 2025.
Types of Corporate Bonds
There are different types of corporate bonds in India that the investors can invest and trade in to realise regular interest payments with the promise of principal repayment:
Zero-coupon Bonds: These types of bonds do not pay regular interest to the bondholders but are available at a discount. The only payment done is for repaying the principal amount at the time of maturity. However, bondholders have to pay taxes on the accrued interest value.
Convertible Bonds: They are hybrid bonds that have the option to be converted to stocks based on the underlying asset of the bond. Once the bonds are converted to regular shares, the bondholders become shareholders and the issuer is not liable to pay interest in the future.
Floating Rate Bonds: Floating rate bonds have fluctuating interest rates and provide different interest payments to the bondholders every time. The coupon rate is based on the prevailing interest rates in the market and the ability of the company to provide a certain interest to the bondholders.
Fixed-Rate Bonds: Fixed-rate corporate bonds, also called vanilla bonds, pay the bondholders a predetermined amount as interest. The coupon rate is fixed at the time of issuance of such bonds and does not change throughout the tenure of the corporate bonds.
Investment Grade Bonds: Corporate bonds are classified based on their credit ratings. Investment-grade bonds are those corporate bonds that have a credit rating higher than BBB- and go up to the highest possible rating of AAA. Investment-grade bonds are issued by financially strong companies and have a negligible possibility of default on payments.
Junk Corporate Bonds: Junk bonds are a type of bond that carries a higher risk of default. The issuer of such bonds may not have the adequate cash flow to pay regular interest or repay the principal amount to the bondholders at the time of maturity. The bonds issued by financially struggling companies are termed junk bonds and generally have higher yields as it is only through a high yield that junk bonds can offset any risk of default.
Default Rates of Corporate Bonds
Although bonds carry lower risk than other investment instruments in the financial market, corporate bonds carry a higher risk than government bonds. It is because a government is highly unlikely to default on interest payments owing to a lack of cash flow. However, corporate bonds are issued by private companies and the promise of regular interest payments and principal repayment is kept until the company has positive cash flow and is profitable. In the case of the company having negative cash flow, it may default on the interest payments or repay the principal amount at the time of maturity.
The default rate is the possibility of corporate bonds defaulting on the interest payments or the principal amount repayment. The investors can calculate the default rate attached to the types of corporate bonds using two methods:
Dividing the number of issuers of corporate bonds who have defaulted on payments by the total number of corporate bond issuers at the beginning of the year. For example, if 500 issuers have defaulted and the total number of issuers at the beginning of the year was 1000, the default rate would be 50%.
Taking the rupee value of the total amount of defaulted bonds and dividing the value by the total par value of all the outstanding bonds.
The default rate of corporate bonds allows investors to ensure they do not invest in bonds that have a high possibility of defaults. It can force the bondholders to incur huge losses and lose the principal amount invested in the first place.
As there are numerous types of corporate bonds trading in India, you can compare all of them based on their face value, coupon rate and credit ratings to invest in an ideal bond to ensure you achieve your financial goals. You can make primary market purchases of corporate bonds from banks, bond traders, brokerage firms, and stockbrokers.
However, you would need a Demat account before purchasing bonds, which you can open with IIFL by visiting the website or downloading the IIFL Markets app. However, it is advised that you analyse all the risks involved with the corporate bond along with the creditworthiness of the issuer.
Frequently Asked Questions Expand All
Among corporate bond types, the most common is the fixed-rate corporate bond. It comes with a fixed coupon rate which is specified at the time of the issuance of the bond. It pays a regular predetermined interest to the bondholders.
For example, A corporate bond has a par value (e.g., Rs. 1,00,000), and the return or interest that you earn or the corporate bond rate is called a coupon (e.g., 5%). If the par value is Rs. 1 lakh and the coupon rate is 5%, you will receive Rs. 2,500 twice a year or Rs. 5,000 annually on your investment until maturity.