2.2.11 Corporate Bonds

Why the extra yield exists

A company issuing a bond is asking investors to lend it money on the strength of its own business, not a sovereign guarantee. Because a business can genuinely fail in a way that a government generally cannot, the market demands extra compensation, the credit spread discussed earlier, to accept that additional risk.

A corporate bond is a debt security issued by a company to raise capital. The company borrows from investors and promises to pay periodic interest (coupon) and return the principal at maturity. Corporate bonds offer a higher yield than government securities of the same maturity because they carry credit risk: the possibility that the company may not be able to meet its obligations. The additional yield above the G-Sec rate is called the credit spread, and it reflects the market's assessment of that credit risk.

A wide and varied category

Corporate bonds range from those issued by large, extremely stable companies with strong credit ratings, offering only a modest premium over government securities, to those issued by smaller or more leveraged companies, offering considerably higher yields to compensate for correspondingly higher default risk. Treating all corporate bonds as one uniform category misses most of the actual decision involved.

India's corporate bond market spans a wide spectrum. At the top end, bonds issued by entities like HDFC, REC, PFC and large banks are rated AAA and trade with narrow spreads of 20-50 basis points above G-Secs. These are considered nearly as safe as government bonds for practical purposes. Below that, AA and A-rated bonds from mid-sized companies offer wider spreads but carry more meaningful credit risk. Below investment grade (BB and lower), the bonds are essentially high-yield or junk-grade, carrying substantial default risk in exchange for even higher yields.

The Indian corporate bond market is smaller and less liquid than the government bond market. SEBI has taken steps to develop it, including mandatory large borrower thresholds (companies above a certain size must raise a portion of their borrowing through bonds rather than bank loans), electronic trading platforms, and standardised settlement processes. Despite this progress, secondary market liquidity remains concentrated in a few large issuers, and many corporate bonds effectively become buy-and-hold instruments because selling before maturity at a fair price is difficult.

How they typically fit a portfolio

High-quality corporate bonds are commonly used to add a modest amount of extra yield over government securities without taking on excessive risk, often through corporate bond funds or banking and PSU funds that concentrate on well-rated issuers. Lower-rated corporate bonds, offering higher yields, are generally sized as a smaller, more deliberate allocation given the meaningfully higher risk involved.