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.
Before we begin, allow me to point out that You Can Be Rich Too With Goal Based Investing is now available at Rs. 307 – a 23% discount at Amazon.in or at Infibeam for at the same price plus an additional 10% discount with coupon code REPUBLIC10
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.
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.
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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