Corporate bond funds: High credit quality, moderate duration risk

Corporate bond funds attracted net inflows of Rs 5,039.1 crore in September 2024, highest among debt fund categories. Their assets under management (AUM) stood at Rs 1,62,570.3 crore on September 30. Before investing, investors must understand the pros and cons of these funds, which experts call an “evergreen category”.

Investment mandate

According to the Securities and Exchange Board of India (Sebi), corporate bond funds must allocate at least 80 per cent to corporate bonds rated AA-plus or higher.

“This is a high credit quality fund with no restriction on its portfolio maturity,” says Mahendra Jajoo, chief investment officer, fixed income, Mirae Asset Investment Managers.

Devang Shah, head of fixed income, Axis Mutual Fund, informs that many funds in this category tend to follow a AAA-oriented strategy.

What led to high inflows?

Global central banks have entered a rate-easing cycle. With the US Federal Reserve cutting rates once and the Reserve Bank of India (RBI) changing its stance, the market is pricing some rate cuts.

“A large part of the industry runs a duration between three and five years in their corporate bond funds. So, this is one investment vehicle investors are using to play the interest-rate cycle,” says Shah.

The corporate bond yield curve is currently inverted, with the three-year yield higher than the five- and 10-year yields. The market expects RBI to cut rates soon. “There is scope for three-year and five-year bond yields to fall. Corporate bond funds, which invest in bonds of these maturities, are hence looking attractive,” says Jajoo.

Joydeep Sen, corporate trainer (debt markets) and author, suggests that investors who do not want to take aggressive duration calls and want a high credit quality portfolio entered these funds in September.

High credit quality  

Fund managers have the flexibility to alter duration depending on the interest-rate outlook. “During a rate hiking cycle, they lower the duration to around one to two years, while in a falling rate regime, they increase the portfolio duration to 4-6 years,” says Shah.

Corporate bond funds offer two key benefits. “One, the credit quality is high, and two, these funds will also gain when interest rates fall, though not as much as longer-duration and dynamic bond funds,” says Sen.

Be prepared for some volatility   

These funds can be volatile due to their duration. “When interest rates rise, the NAVs of these funds will fall,” says Jajoo. However, they won’t fall as much as longer-duration funds.

In certain environments, such as during the taper tantrum of 2013-14 and Covid, government securities outperformed corporate bonds. “There can be market environments in which corporate bonds underperform government bonds, though spreads tend to reset over the medium term,” says Shah.

Key criteria for fund selection 

Assess the credit rating allocation in a corporate bond fund. “Also, look at the duration profile of the bonds,” says Mayank Misra, vice-president of product management, mutual funds, INDmoney.

Look up the fund’s potential risk class (PRC) and the risk-o-meter, which show its potential and current risk. Jajoo suggests checking the fund manager and the AMC’s long-term track record, and the fund’s portfolio turnover and Sharpe ratio.

Larger funds, with higher AUM, are less impacted by redemption pressures. “A higher AUM gives fund managers more bargaining power with debt issuers, leading to better returns,” says Misra.

Sen recommends a 40 per cent exposure to corporate bond funds in debt fund portfolios and a three to four-year horizon.