Smart Ways to Invest in Corporate Fixed Deposits

Have you ever wondered why a corporate fixed deposit offers a higher rate of return than a bank deposit? Have you ever considered investing in corporate FDs, but worried about the “risks”? In this post, I simple ways to invest in corporate fixed deposits.

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The reason why corporate FDs offer higher return is because their reputation is not as good as a bank FD. So if we look at only the return, we ignore the risk.  If we look at only the return, then we have to settle for less.  There is a middle path via debt mutual funds.

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Before we consider the types of debt mutual funds to invest in, let us ask another question: What is the difference between Equity Mutual Fund Investing vs Stock Investing? This is key to understanding the difference between a debt mutual fund and corporate FD.

A stock investor typically has anywhere between 5-15 stocks  (above that it is a mutual fund folio!). The risk is concentrated in these stocks and so is the reward. A fund manager cannot by design afford to take such concentrated bets. A fund cannot hold more than 10% of a stock. This dilutes both the risk and (potential) reward.

So a person who can afford to take such a concentrated risk can choose direct equity over mutual funds. The reward may or may not be higher. It is stupid to assume any old joe can be a fund manager.

The analogy with corporate FDs should be clear. Buying a corporate FD is taking a highly concentrated risk, even if the issuer is AAA rated. If the rating drops, interest payments will get delayed and there could also be a default.

A debt mutual fund spread this risk across a basket of corporate FDs (and other types of bonds) – the same 10% limit now applies to debt funds also after the JP Morgan Debacle.

There are three choices here, each with its own pros and cons.

Open-ended income funds

Open-ended income or corporate bonds funds is probably the most straight forward choice.  A fund link Franklin Corporate Bond Opportunities with an average portfolio maturity of 3-4 years can be used for long-term goals 10s of years away.

Pros: Open to subscription and redemption at all times. So one can conveniently invest each month and rebalance at will.

Cons: If the credit rating of a bond in the portfolio is degraded, the NAV will fall. Investors may panic and start redeeming. SEBI now has rules that prevent AMCs from limiting redemptions unless there is a market-wide crisis.

So if a single bond fails, redemptions cannot be stopped. The AMC may panic and sell it at a loss. This will result in a permanent loss in NAV.

A credit rating downgrade will result in a temporary NAV drop IF the issuer honours all payments and gives back the principal on maturity. Here is an example: Debt Mutual Funds: NAV Recovery after Credit Rating Downgrade

Closed-ended Debt Funds: Fixed Maturity Plans

If you do not know what a fixed maturity plan (FMP) is, then I suggest you read this and then come back here: How to Select Mutual Fund Fixed Maturity Plans (FMP)

Pros: Typically if an FMP has a tenure of 3 years, the bonds will the portfolio will match that tenure.  Since the fund is closed, there will no panic selling if a bond is degraded.

Cons: FMPs these days have a minimum tenure of 3 years. They are no liquid and the money will be locked-up till maturity. This makes portfolio management and monthly investing impossible with FMPs. Unless one buys a new FMP each month, which would be silly.

Semi- closed-ended Debt Funds: Internal Funds

An interval fund will remain closed for subscription and redemption for a specified interval, open for about two days, when the money can be redeemed and more invested and then close for the interval and so.

For example, a fund can be closed for 367 days after the NFO period, open for transactions in the 368 and 369th day and then remain closed for next 367, open for next two days and so on.

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Those two days are known as specified transaction period (unfortunately called STP – not to be confused with systematic transfer plan)

Read more about them here: Introduction to Interval Income Mutual Fund Schemes

Pros: The fund can only hold that mature on or before the interval period: 367 days in the above example. So if I choose an annual interval fund, I take a bit more risk than if I choose quarterly or monthly interval funds.  This helps the investor control the credit risk they take, much better than the other two options.

One can invest in old interval funds during the next STP.  One cannot invest in old FMPs.

FMPs have an interval of minimum 3Y+1day to escape short tem taxation as per slab. Interval funds ( at least the old ones) do not have to set the interval based on tax rules.

Monthly, quarterly or annual investing is possible with interval funds.

Cons: They are not popular, have low AUM and could close it there is not enough interest among investors (a pity because it is a great way to invest in corporate bonds).

Just like FMPs, fast-food-free-lunch is not available. One will have to read the scheme information document to understand where the scheme will invest. Not suitable for lazy investors.

They are illiquid in between two STP periods – 367 days in the above example.

For those who can handle NAV ups and downs, open-ended income funds are simpler and can be used for medium and long-term goals. Interval funds can be used to invest say once a year if that is convenient.

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7 thoughts on “Smart Ways to Invest in Corporate Fixed Deposits

  1. It is apparent from your article that you have either no experience in investing in Corporate FDs or you have had a bad one. I have been investing in these FDs all my adult life and have had an excellent experience with them. You say the reason why corporate FDs offer higher return is because their reputation is not as good as a bank FD. This is absolutely FALSE. Are you saying that the reputation of companies like Tata Motors, Tata Power, Tata Steel, Mahindra & Mahindra , Godrej & Boyce, HDFC Ltd. is not as good as the the sick public sector banks ? These companies give higher interest rates because the rates are lower than the interest rate they will have to pay on bank loans including the cost of managing fixed deposits. It is has nothing to do with their reputation.
    I never had a problem with corporate deposits for repayment on maturity or interest payments because I chose to invest in reputed companies like those I have mentioned above. Even a company like United Spirits has not relegated from interest and maturity amount payments. What is not known to the general public is that Corporate FDs are regulated by the RBI thus reducing the risk of these deposits.

    1. wow! How typical! “I have had no problem with them”. So this automatically means that those who talk about risk are wrong. Good luck. Those who understand the concept of risk premium will recognise why an alpha is necessary as the credit rating goes down.

  2. Just a few points to make. Corporate FDs are regulated by the Ministry of Corporate Affairs and frankly, God help an investor if his company defaults on its FD commitment. The earlier rules were changed in 2014 for the worse and an investor has practically almost no rights now, but has to wait till he gets his money back. The funds raised through corporate FDs were meant to be for short term use, but corporates used them for long term purposes, which is why many corporates have defaulted on FD interest and principal repayment for almost 2 years now. There are next to no good manufacturing companies or borrowers in the service sector offering FDs, mainly finance companies now offer FDs.
    One area to note is non convertible debentures or bonds (tax free or taxable interest), which has seen many public issues in the last decade. While liquidity remains a concern in these securities, there have been almost no defaults, as the borrowers typically raise debt regularly and therefore stand to lose their reputation if they default. The last 2 years have seen good interest in bonds, with most issues getting fully subscribed the first or second day. Investors looking at stable incomes should look at bond issues with high credit rating, these rates are typically higher than bank FDs or even the mutual funds.

    1. All good points. The only issue is, there are not many sellers for tax-free bonds and even present, the market value is available at a premium. So this reduces the benefits to an extent.

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