Corporate bonds are important debt instruments issued by companies to raise funds for different purposes. Some of the reasons could be expanding a business, managing day-to-day operations, and refinancing existing debt.
When you invest in a corporate bond, you are lending money to the company. In return, the company agrees to pay you the corporate bond return rate. The interest rate is also known as the coupon. The company repays the principal amount when the bond matures.
How Do Corporate Bonds Work?
When the company issues a bond, it is typically borrowing money from investors like you. In turn, you become creditors to the company. There is a specific corporate bond return rate referred to as the coupon rate. The company will pay you this amount at regular intervals, either annually or semi-annually. Moreover, bonds also feature a maturity date at which the company is expected to repay the principal amount to the bondholders.
The market value of corporate bonds tend to vary depending on several factors, including the credit rating of the company, changes in interest rates, and the existing economic conditions. Investors can consider buying or selling bonds on the secondary market, where prices tend to vary from the original issue price.
Types of Corporate Bonds
- Zero-coupon Bonds: These bonds will not ensure regular interest payments. Rather, they are usually sold at a lower price than the respective face value. As such, the bondholder receives the full face value as the bond matures.
- Floating-rate Bonds: The interest rate on these bonds tends to fluctuate periodically. The interest rate here is determined by the standard set rate at regular intervals.
- Fixed-rate Bonds: These bonds provide a set interest rate and offer regular, predictable interest payments throughout the life of the bond.
- Callable Bonds: In this case, the issuer has the option of repaying the bond before the same reaches maturity at some predetermined price. This offers the issuing company ample flexibility to reduce or refinance the debt when favorable conditions are met.
- Convertible Bonds: With these bonds, investors are given the opportunity to convert bonds into a fixed number of shares of the issuing company. This offers the bondholder the chance to convert bond into equity under specific conditions.
Key Features of Corporate Bonds
- Liquidity: Corporate bonds can be purchased or sold in the secondary market before the maturity period. However, the liquidity might vary based on the market conditions and the bond issue.
- Maturity Period: Corporate bonds feature different maturity periods. The period typically ranges between a few months and as long as 30 years. Investors will receive the principal amount back when the bond matures.
- Convertible and Callable Features: Some corporate bonds tend to be callable. This means that the issuer can redeem the same before the bond’s maturity date. At the same time, some bonds are convertible. This allows bondholders to convert them into relevant company shares.
- Tax Implications: Interest earned out of corporate bonds is taxable according to the income tax bracket of the investor. Bonds that are held for more than three years might qualify for long-term capital gains tax featuring indexation benefits.
Benefits of Corporate Bonds
- Interest Rate and Bond Prices: As the market interest rate drops, existing corporate bonds featuring a higher coupon rate tend to become more lucrative. Therefore, investors will be more willing to pay a premium for such bonds as they will yield better outcomes in comparison to new bonds at reduced rates.
- Higher Yields: When compared to other financial instruments, corporate bonds typically offer more attractive returns, especially when compared with fixed deposits or government bonds. However, it is important to understand that higher returns will come with higher risks. This is because returns are linked to the creditworthiness of the issuing company.
Taxation of Corporate Bonds in India
- Interest Income: Interest earned out of corporate bonds is completely taxable in the form of ‘income from other sources.’ The interest is taxed at the available income tax slab rate of the investor.
- Capital Gains: STCG or Short-term Capital Gains is applied if the bond is sold within 3 years of the purchase. On the other hand, LTCG or Long-term Capital Gains is taxed at the income tax slab rate of the investor. LTCG is applied when the investor holds the bond for more than 3 years. It is usually taxed at 20 percent with indexation benefits, or 10 percent without indexation, which might be lower.
- TDS: Tax Deducted at Source (TDS) is deducted on the respective interest payments at a rate of 10 percent for resident individuals and HUFs (Hindu Undivided Families). For non-resident investors, TDS is typically deducted at 20 percent or according to the applicable tax treaty rate.
- Zero Coupon Bonds: The difference between the buying price and the redemption price is referred to as the interest income. This income is taxable during the year of redemption or transfer.
- Indexation Benefit: These benefits are available for LTCGs on corporate bonds that are held for more than 3 years. Indexation benefits help minimize the tax liability by adjusting the buying price for inflation.
- FCCBs: Foreign Currency Convertible Bonds have the interest income taxable for resident investors. For non-resident investors, there are specific provisions depending on the respective tax treaties.
- Listed vs. Unlisted Corporate Bonds: In case of listed bonds that are sold on a reputable stock exchange, LTCG is taxed at a fixed rate of 10 percent without indexation benefits. STT or Securities Transaction Tax is applicable on sale. In case of unlisted corporate bonds, the general rule of 20% with indexation benefits is applied.
Conclusion
Corporate bonds offer a lucrative investment opportunity to those who are looking for a steady source of income with a low-risk profile. These bonds are also attractive for investors who wish to mitigate risks in an equity-heavy portfolio. The overall potential of these bonds to ensure steady returns with ample tax benefits makes them highly attractive for most investors.