Corporate Bonds

Bonds that are issued by private and public corporations are known as corporate bonds.

In the previous module we learnt about bonds issued by government but governments are not the only entities that raise debt through bonds. Bonds that are issued by private and public corporations are known as corporate bonds. Companies may issue debt to raise money for a variety of purposes for example to raise money for a new plant and these bonds act as a way for people to lend money directly to the company.

Not all bonds are made equal (AKA Credit Risk)

If you have compared fixed deposit rates at various banks, you would have noticed the big three (SBI, HDFC, ICICI) tend to have lower interest rates on their fixed deposits when compared to smaller players. The other end of the spectrum tends to be small finance banks which tend to offer a good 3-4% over what a major bank would offer. This parity in rates is due to risk and the same applies to bonds issued by companies. Bonds issued by a robust bluechip company has a much lower chance of default than one issued by a shakey unprofitable smallcap.

There needs to be a way gauge this risk and that is why we have something known as a credit rating. Credit ratings are like your CIBIL scores, just for companies. Broadly speaking there are:

  • CRISIL Limited

  • India Ratings and Research Pvt Ltd

  • ICRA Limited

  • CARE

  • Brickwork Ratings India Pvt Ltd

  • SMERA Ratings Limited

  • Infometrics Valuation and Rating Pvt Ltd

Generally, speaking a company issuing debt will get themselves rated by one or more of these agencies and they will issue a grade to their company based on the category. There is a separate rating and rating scale for each type of debt issued - long term debt, short term and FDs (there are more subcategories but we will limit ourselves to the three main types).

As the names imply each rating is tailed for the specific type of debt security issued. Each rating agency has their own scale which is publicly available but most ratings go from AAA (safest) to D (default) with BBB being the lowest possible grade for investment grade debt (Colloquially, AAA is commonly used but short term debt is usually rated from A1 to D where A1 is the equivalent to AAA). Any debt with a rating less than that is considered to be junk debt and often will not get investments from pension funds, some mutual funds, etc due to guidelines by their regulators. Colloquially, some bonds are considered to "pseudo SOV rated". These are generally bonds issued by PSUs and PSBs and there is an assumption that the government will recapitalize these entities incase of a default. There is some merit to this argument but it is prudent to assume some risk as there is no guarantee that requirements the government to bail out bond holders.

While a useful metric to analyse the overall risk, it is important to note that these ratings are merely a reference and taking these ratings at face value can backfire and history has several examples of this - the meltdown of AAA rated Mortgage Backed Securities (MBS) during the 2008 financial crisis.

Types

There are a couple of types of debt based securities that companies can issued and these have different consequences both for the company and the investor.

Corporate Fixed Deposits

Corporate Fixed Deposits are similar but not the same as bank deposits in that they are not market based securities. Similar to how you would do in a bank you can deposit a variable amount of money for a duration of your choice provided by the company. Unlike a bond these are not market based, which means liquidity is provided entirely by the company. If you want to exit a traditional bond then you can do that at any time by selling the security in the secondary markets ie the exchanges NSE/BSE through your broker (though you might end up selling for a discount if there isn't enough liquidity). This is not possible with a corporate fixed deposit as these are not listed, if you want to get your money back early then you need to go through their early withdrawal process which may have a penalty of 1-2% on the interest.

Furthermore, it is very important to note that corporate fixed deposits are not backed by RBI and DICGC's 5L insurance and if the company goes insolvent then there is a risk of default and the only option for you would be either to sue or wait to get your proceeds from any resulting liquidation process. The "reward" for taking this is risk is usually a much higher rate of interest over bank fixed deposits.

In terms of taxation, these are taxed similarly to bank FDs and tax is deducted at source unless you provide a 15G/H form if you're under the tax slabs.

Non Convertible Debentures (NCDs)

Non‐Convertible Debenture is a financial instrument issued by Corporates for specified tenure to raise funds through public issue or private placement. The non convertible in the name implies that the debentures are not convertible to equity (some types of convertible debentures can be swapped for equity shares for example). These can be issued by Companies, including Non-Banking Finance Companies (NBFCs) or any corporate bodies worth more than ₹100 crore that are permitted to issue debt by the Reserve Bank of India. Furthermore, these issuers must be rated by at least one Credit Rating Agency(CRA). If they plan to issue ₹1000 crore or more in debt they must be rated by two CRAs. The minimum credit rating must be atleast A3 for issue.

Unlike a fixed deposit these are listed securities and investors can exit their investment by selling the debentures on the markets. As with any market linked securities these can suffer from changes to interest rates ie a rise in interest rates can make your NCBs to be worth less and vice versa. There can also be a spread (ie if the debenture is worth ₹100, sellers might want 104 while buyers offer only 96 which means you lose money both to enter and exit) due to a lack of liquidity in the market for the particular instrument. As with any corporate instruments, NCDs, are not backed by RBI and DICGC's 5L insurance and if the company goes insolvent then there is a risk of default. There are two types of NCDs:

  • Secured: Investors can claim the company's assets incase of a default

  • Unsecured: Investors can't directly stake a claim on the company's assets

In terms of taxation if NCDs are sold within a year or lesser STCG will be applicable as per the income tax slab rate. If the NCDs are sold after a year or more or before the maturity date, LTCG will be applicable at 20% with indexation. For those in higher tax brackets these may be superior to holding FDs.

Bonds

Bonds are a financial instrument issued by Corporates for specified tenure to raise funds. These are most part very similar to Non‐Convertible Debentures however with some key differences

  • Bonds are generally issued by larger, public corporations whereas NCDs can be issued by unlisted corporations as well

  • Bonds are usually secured and furthermore incase of an insolvency proceeding, bondholders are higher in the line of recovery ie if there are sales of the company's assets bond holders will be the first to get their money followed by NCD holders (then commonly preferred shareholders and finally regular equity holders who are the last ones to get if anything is left by then).

  • Due to the lower risk nature of bonds compared to NCDs, NCDs will have a higher yield than their Bond equivalent.

Capital Gain Bonds (54EC Bonds)

While not strictly a sub category of debt, these are bonds that relevant to Real Estate investors as they are a way to gain some respite from capital gains taxes. Do note we will not go in depth into the exact details of how capital gains works in case of property but this section applies on all the gains after brokerage, indexation, expenses, etc are subtracted from the sale price. This final capital gains amount can be then invested in these 54EC bonds as a way to avoid the tax burden. To be eligible for this exemption there are three key requirements

  • The amount you invest should be sourced from the gains you have from the sale of property

  • The amount should not exceed 50 lakhs for individuals or 50L per partner in a real estate business

  • Investment shall be made within 6 months of date of sale or filing of your IT return

Currently, three companies issue bonds under this category and you can invest in them through your bank.

  • REC (Rural Electrification Corporation Ltd)

  • PFC (Power Finance Corporation Ltd)

  • NHAI (National Highways Authority of India)

The key details to note about these bonds are

  • As of today, all 54EC bonds are AAA rated PSUs (which are partially divested by the Government)

  • TDS is not deducted on interest from 54EC bonds and they are exempt from Wealth Taxes

  • They are issued with a lock-in period of 5 years

  • Minimum investment in 54EC bonds is 1 bond amounting to ₹10,000