If you’re considering buying corporate bonds, it’s important to understand what exactly that entails and the best ways of trading in bonds in order to secure the best returns and minimise risk. The following is a beginner’s guide to purchasing corporate bonds, including what types of bond are on offer, what to look out for, and, importantly, where to trade.
What is a Corporate Bond?
Corporate bonds are a way of lending money to businesses, and other organisations, looking for funding. At its most simple, a corporate bond is an IOU for money lent to a company in return for an agreed number of interest payments (normally a fixed percentage of the price of the bond). The company must then repay the capital at maturity – after a set period.
It’s important to understand, however, while corporate bonds generate income, they do not offer capital growth if they are held to maturity (although as we’ll see later the repayment at the end of the term can be higher, or lower, than the initial investment).
While corporate bonds and gilts (fixed issue securities issued by the British government) are very similar, corporate bonds are by definition a riskier option as businesses are much more likely to go under, or default, than the government. However, to reflect this risk, they offer a higher rate of return.
Unlike shares, corporate bonds do not give you a stake in the company. Instead, you are a creditor. However, you are prioritised above shareholders should the company fail. Just be aware that you may not get your full investment back – unlike shareholders who, in the event of the company going under, will lose everything.
Trading Corporate Bonds
Most corporate bonds are traded on a secondary market (i.e., you don’t have to hold them to maturity) but their value can fluctuate based on interest rates and the solvency of the issuer. The price of a bond can also be affected by the general economic environment and broader market conditions.
For instance, if there’s a bull stock market, then investors may reduce their exposure to bonds and divert that cash into shares. Conversely, if the stock markets take a hit, investors will flee to the relative security of the bond markets.
Bond prices typically rise when interest rates decline. Corporate bonds will offer more attractive rates of interest than banks can on deposits. When trading above or below their nominal value, they are defined as trading ‘above par’ and ‘below par’, respectively. This affects yield, as well as the repayment value received at the end of the term versus when you purchased.
This can be demonstrated by looking at an example:
If a corporate bond has a nominal value of £100, but you buy it for less, say £90, you’ll make a capital gain of £10 for each bond when it matures. Likewise, the amount of interest you receive will also be affected by the price you paid for the bond, as interest is paid based on the nominal value, not the second-hand market price.
In effect, in this example, you would get more bang for your buck. The official term is ‘redemption yield’. This is the actual rate of return based on combining the interest rate paid for the bond and the profit (or loss) achieved when holding the bond to maturity.
Here’s a simple calculator that will show you the current yield (actual interest returned) on a corporate bond that has a current price that is different from its par value/original issue price:
Risk and Reward
Like many investment vehicles, corporate bonds are given ratings by the likes of Moody’s and Standard & Poor’s. Those rated AAA to BBB are considered ‘investment grade’. These are lower risk bonds featuring stable, financially sound, performing businesses, such as well-established utility companies and major supermarket chains.
On the other hand, ‘high yield’ bonds, also known as ‘junk bonds’ are a riskier type of corporate bond issued by companies that have a higher chance of defaulting (rated Ba1/BB+ or lower, by Moody’s/S&P). Consequently, though, these do attract a higher rate of interest.
The credit quality of a bond issuer is crucially significant for bonds. If a bond is downgraded, then the market will react unfavourably and the value of your investment could drop significantly (of course, if the opposite happens and the bond is upgraded, the value will increase).
Although this shouldn’t matter so much if you hold to maturity, selling before then could significantly affect how much capital is returned. While investment grade bonds are good for a steady income and portfolio diversification, high yield bonds have performed exceptionally well in recent years.
Between 30th December 2000 and 30 Dec 2019, high yield corporate bonds such as those available from Wise Alpha averaged 10.7% annual returns. Default rates on high yield bonds are typically pretty low, as depicted by this chart.
Why Buy Corporate Bonds?
Due to low risk and solid returns compared to shares, corporate bonds have become very popular among investors in recent years. Another reason is that interest rates have been at historic lows for a sustained period of time. As a result, many corporate bonds (and funds) have performed better than expected.
There are several reasons why investors choose corporate bonds, but perhaps the biggest advantage is that they provide a reliable income stream, typically in the form of a bi-annual payment. Of course, upon maturity the initial investment is returned so it’s also a low-risk way to protect your capital.
Furthermore, if you have already have a portfolio of other investments, then corporate bonds are an excellent way of diversifying your portfolio and minimising risk.
Finally, should you need access to cash quickly, in most cases you can easily liquidate your investment on the bonds markets.
Kinds of Bond that can be Purchased
There are a lot of types of bonds out there you can invest in. These are the main categories:
These can be bought from the London Stock Exchange’s Bond Platform. The Order book for Retail Bonds (ORB), was launched on February 2010. This was done to encourage firms to go direct to personal investors with smaller amounts to invest, as opposed to the larger corporate bond market dominated by institutions.
The minimum investment for investors is usually £1000 – although you can get involved from as little as £100. These can be bought and sold through brokers and investment platforms (which we will speak more about later).
Corporate Bond Funds
Most individual investors buy corporate bonds through funds, which invest in a number of companies in order to spread risk. However, this does mean paying fees to a fund manager (typically 0.5%-1%).
In return, the fund manager does a lot of work for you, taking advantage of swings in the market to deliver a return based on the income from the bond, as well as added income from buying below the nominal value and selling above the nominal value.
Theoretically, it’s the job of your fund manager to ‘turbo-charge’ your investment. However, this doesn’t come without risk, as economic factors or rising interest rates can affect how successful your fund manager is at their job.
It’s worth pointing out since the fund invests in a number of companies, there is no maturity date. Corporate bond funds tend to come in four flavours, depending on the breakdown of the investment:
- Standard corporate bond funds –80% must be investment grade corporate funds.
- Global corporate bond funds – 80% in overseas investment grade corporate funds.
- Strategic bond funds – 80% in fixed interest, including convertibles (bonds that can be converted into shares), preference shares and permanent interest-bearing shares.
- High yield funds – 80% in high yield funds. Better returns but higher credit risk.
Mini-bonds – While mini-bonds are corporate bonds for private investors, they are unlisted products that cannot be traded on the Orb market. These are generally issued by small companies, such as hoteliers, sports clubs and restaurants.
For this reason, they often come with perks such as discounted products or services. Returns can be high (as much as 15%), but the risks are substantial. They are non-transferable and non-convertible – you must hold them for the full term.
Firms can, and do, fail. And you won’t be covered by the Financial Services Compensation Scheme if that happens, so it’s important to thoroughly research the businesses before you decide to invest.
P.S. It’s worth pointing out here that the regulation of mini-bonds is currently under scrutiny by the Financial Conduct Authority (FCA).
- UK Government bonds – As touched on earlier, government bonds, or gilts, are backed by the government and thereby carry less risk than other types of bonds. The interest paid on gilts is linked to the Retail Price Index (RPI), so their value rises with inflation. Gilts can be bought directly from the government’s Debt Management Office.
Which Corporate Bonds to Buy
While the creation of ORB in 2010 increased the uptake of corporate bond purchases by making it easier for smaller investors to trade bonds, trading in corporate bonds is still viewed as a market dominated by institutional investors.
However, new platforms such as a WiseAlpha have come along to challenge that paradigm. Just make sure, before taking the plunge into the heady world of corporate bonds market, you know what you’re getting into.
Factors to consider before investing in corporate bonds
- Research your investment. If a company goes bankrupt, you could lose your entire investment.
- The longer the maturity period, the more susceptible your investment is to interest rates. Rising interest rates can significantly affect the price of the bond -you could get less back than you put in.
- Rating agency downgrades/upgrades can cause credit spreads to widen/tighten, respectively. In turn, this can cause the price to fall/rise, respectively.
- In the case of long term corporate bonds, inflation has the potential to erode your return.
How to Buy
While you have a choice of brokers to buy corporate bonds, experienced investors have much to consider for the best choice of investment option, competitive pricing structures as well as real control when it comes to features, functionality and accessibility.
Here are six of the best choices:
- eToro Exchange Traded Funds – This is one of the best-known investment trading platforms and it has a lot of variety. Here, as well as trading CFDs, they have well over 100 ETFs that you can invest in. This includes a small number of corporate bonds ETFs such as the iShares iBoxx Investment Grade Corporate Bond ETF (‘LQD‘), Vanguard Total Bond Market ETF (‘BND‘), Pimco Total Return Active EX fund (‘BOND‘), iShares Core International Aggregate Bond ETF (‘IAGG‘) and the iBoxx $ High Yield Corporate Bond iShares ETF (‘HYG‘).
PropertyCrowd – As the name suggests, PropertyCrowd deals with corporate bonds in the property sector. A fast-growing niche for investors, property bonds work exactly the same way as corporate bonds but are raised by property developers.
This can make them highly risky and not really for beginners to bond investments. But, if you’re looking for a platform that specialises in property, PropertyCrowd might be up your street.
Hargreaves Lansdown – As one of the most established and reputable brokers in the UK, Hargreaves Lansdown covers a huge range of assets and boasts a big selection of tools for research and analysis. But all of this comes at a price.
Hargreaves Lansdown is clearly one of the more premium brokers in the market when it comes to fees. There is a full range of corporate bonds on offer, but the focus tends to be on gilts. Frustratingly, to invest in corporate bonds, you need to call the broker directly – not ideal for those who want the ease and flexibility of online trading.
- Saxo Markets – This fully featured online platform gets full marks for being user-friendly. It even comes with a handy app for checking up on your investments on the move but, like Hargreaves Lansdown, covers a vast range of markets across the globe, so can be confusing for some investors – especially if you want to focus solely on the corporate bonds markets. That said, fees are attractive.
- IG Group – Founded in 1974, IG Group has maintained its popularity over the years with traders through solid customer care and competitive commissions. Today, however, IG Group tends to specialise in spread-betting, CFDs (Contract for Difference) and cryptocurrency trading, so if you’re looking for a platform with real corporate bonds expertise, it might be better to look elsewhere.
- WiseAlpha – With a five-star rating on TrustPilot, WiseAlpha has been making waves with experienced investors and high net worth individuals thanks to their fractional bonds. An intuitive interface, coupled with a responsive customer service team, transparent pricing and real expertise in the corporate bonds markets have made WiseAlpha my personal choice in 2020.
Frequently Asked Questions
What is a corporate bond?
It's debt issued by a company. If you buy a corporate bond, you have effectively given the company a loan that they will pay a fixed amount interest on before returning the full principal at the end of the loan term.
Can I lose money by investing in bonds?
Yes, you could lose it all, although default rates are typically very low. Checking the credit rating of the bond will give you an indication of the level of risk involved.
Can't corporate bonds only be bought by investment funds?
This was once the case, but it isn't anymore. It's now possible to buy them using the innovation of fractional bonds.