May 29, 2023
Corporate bonds are an alternative to company stocks that offer your portfolio diversity, enable you to receive income and earn higher yields than government bonds.
If you’ve been wondering how to trade corporate bonds, what they are or how they work, learn all about this financial instrument in this in-depth guide.
What are corporate bonds?
Corporate bonds are a simple debt instrument; a way for corporate entities to raise capital. By purchasing a bond, you become a creditor of that company, or bondholder. The company, or bond issuer, agrees to make interest payments to the bondholder, known as coupons. The coupon rate is calculated as a percentage rate of the loan amount. This coupon rate is paid on specific dates nominated within the bond documents, on coupon dates. At the expiration of the bond, known as maturity, the issuer agrees to repay the full loan amount. This amount is called the principal, or face value.
How do corporate bonds work?
Corporate bonds, unlike government bonds, are issued by private institutions, and they are generally known to offer a slightly higher risk/reward threshold than government issued debt bonds. Company bonds can be secured, which means that corporations will put up certain assets as collateral for the bond. In some cases, the coupon rates of company bonds are fixed, and in other cases, they may be floating and tied to market interest rates.
Corporate bonds are considered a negotiable security, which means they can be bought and sold on a secondary market. Within this market, company bonds are sold for an issue price, which is a value related to, but not the same as, the principal. Reselling company bonds offers chances for traders to take on a bond with a better yield. This means that the sale price of the bond is less than the principal, and in turn the coupon rates give the new buyer a better overall yield on their investment than the original bond’s terms.
For example, say a £10,000 corporate bond is issued with annual coupon rates of £500. The yield of this bond is 5%. If that corporate bond was to be sold for £9,500, the coupon rates would remain £500 per annum, but the yield for the new bondholder will have increased.
As well as buying and selling company bonds on secondary markets, another way to gain from this debt instrument is by learning how to trade bonds through OTCs.
How to trade corporate bonds
Investing in corporate bonds can take the form of buying company bonds when they are issued by the corporate institution, or buying and selling them on a secondary market. Both of these methods are good ways to gain exposure to company bonds. Another way is by trading on company bonds.
For traders who want to gain exposure to corporate bonds but not take possession of the underlying asset, one option is to hedge an existing position you have in the market, mitigating against potential losses. Bond CFD trading is one way to short sell the bond futures market. CFD trading works through leverage, and it’s important that you understand the risks associated with this type of trading.
Leverage is a type of trading which means an initial deposit, calculated as a percentage margin of the full asset face value, is all you need to put down to gain full exposure to the total value of the company bond. This means that if you make a profit, the win will be magnified. However, losses can also be increased, and may exceed your initial deposit amount.
No matter what kind of trading strategy you use to trade corporate bonds, you’ll also need a powerful platform to help you monitor your open positions and watch the market to identify trends and relevant developments. At VT Markets, we offer our clients MetaTrader 4 and its newest generation successor, MetaTrader 5, to trade in open markets.
Why do people buy corporate bonds?
Investing in corporate bonds is an attractive option for a number of reasons:
- They can help you diversify your portfolio
- They allow you to speculate on the movement of interest rates
- They provide income through coupon rates
- They can earn you higher yields than government bonds if you’re willing to take on more risk
- They’re a highly liquid asset, able to be sold at any time on a secondary market that tends to have a healthy appetite for reselling
What are the risks?
As we’ve mentioned, corporate bonds are considered less risky than other kinds of financial assets and instruments, but no trading is completely risk-free. Here are some of the risks you’ll need to be aware of when learning how to trade corporate bonds.
- Credit risk — This is the term used to describe the risk of a corporate issuer defaulting on either the coupons or principal of a bond. Credit ratings help traders assess this risk through investment rating grades. The best rating corporate bonds can receive AAA rating, with riskier bonds falling into BB grades and lower.
It’s important to be aware that a company bond’s credit rating can change over the active life span of the bond. In particular, adverse business conditions could affect a corporation’s risk of default.
- Interest rate risk — All bonds have a close relationship to interest rates, because how attractive a corporate bond is to investors depends on how its coupon rates compare to current interest rates.
When interest rates rise, investors may lose interest in company bonds, favouring investments that may produce a better yield for them. In times of depressed interest rates, demand for corporate bonds can be expected to increase.
- Inflation risk — Inflation will also impact the value of corporate bonds. In times of high inflation, these bonds will command less purchasing power, making the coupon rates less attractive.
Interest rate increases are also used as a financial tool for controlling inflation, which means that inflation rates could cause an interest rate rise that makes your corporate bonds less attractive. If the inflation rate increases above the coupon rate of a bond, it could also lose money in real terms.
- Liquidity risk — Liquidity risk refers to situations where there may not be enough buyers in the market to quickly offload your company bonds. This lack of demand means that traders may have to sell their bonds for a lower issue price than its coupon price and face value.
- Currency risk — This risk refers specifically to company bonds which were issued in and paid out in a different currency to your reference currency. In a situation like this, currency exchange rates can become an issue that affects the overall value of your investment.
- Call risk — A call risk is produced when a company has the right, but not the obligation, to repay the principal before the maturity date of a corporate bond. This is undesirable for investors because it means you’ll miss out on coupon rates that you would have otherwise been paid during the active lifespan of the bond.
Start trading corporate bonds with VT Markets today
If you want to start trading corporate bonds, VT Markets makes it easy to gain access to open markets, learn how to implement trading strategies, open positions and monitor them using our state-of-the-art trading tools, daily market analysis, expert advice and investor insights.
You can practise your corporate bond trading strategies using a demo account, which gives you access to a live trading environment with a risk-free, no obligation 90 day trial period. Then, when you’re ready to go live in an open market, create a live account and start opening and monitoring positions. Wondering how to set up your online trading platform? Ask our team for help to get started.
FAQs
How risky are corporate bonds?
All trading and investment comes with a certain degree of risk, however, the bond market is considered to be lower risk than other types of trading. Both government and corporate bonds are rated by external agencies like Standard & Poor’s, Fitch and Moody’s, who provide an investment grade that indicates how risky any given corporate bond is considered to be.
Are corporate bonds safer than stocks?
Corporate bonds offer investors a very different product to stocks. Stocks are shares in a company; owning them entitles you to certain voting rights and makes you a stakeholder in the company. Owning corporate stocks allows you to benefit from increased share prices, but it also means that you could lose money if the value of the company takes a dive.
In contrast, company bonds establish you as a bondholder, or creditor of a corporation. You loan that company an amount of money for the duration of the loan, until the maturation date. During this period, the corporation will make interest payments in the form of coupons, and then repay the principal at the expiration date of the bond.
Unlike with shareholders, bondholders won’t gain voting rights or a slice of the company’s profits, but they also expose themselves to less risk. Corporate bonds can be guaranteed by company assets as collateral, and if the company becomes insolvent, bondholders will be paid out their principal before shareholders, a concept known as liquidation preference.
How do I start trading corporate bonds?
One of the options for starting to trade bonds is to deal with over the counter products, also known as OTCs, which are traded through institutional broker-dealers. Bond CFDs are one such product. Contracts for difference, or CFDs, allow traders to speculate on the price movement of corporate bonds, rather than the value of the underlying asset itself. This means that traders have an opportunity to benefit from both profits and losses within the market, because they are speculating on where the price will move, rather than betting on a price increase only.
Bond CFDs are complex financial instruments, and they require traders to thoroughly research the market and understand different CFD trading strategies. They are leveraged financial products, which means that you gain full exposure to the asset based on just a marginal deposit. Your profits can be amplified with CFDs, but you can also potentially lose more than your initial deposit amount. For these reasons, learning how to trade CFDs requires time, education and appropriate risk management tools.
