How to trade bonds

Introduction

Bonds are second only to stocks and shares in their importance to retail investors.  Learning how to trade bonds is a crucial, but sometimes neglected skill for anyone looking to diversify their investment portfolio, or capitalise on interest rate movements. Unlike stocks, bonds offer a predictable income stream, making them attractive to risk-averse investors and those seeking stable returns. Day traders can also use bonds either as a hedge on other positions or to express a view on the main drivers of bond prices, which include the credit worthiness of the issuer and interest rates.

“Day trading bonds is very different to other assets, since they are redeemed at par, representing the initial value of the bonds issued”

What are bonds?

Bonds are a type of fixed-income asset, which represents a loan to the buyer by the borrower. The buyer of a bond receives a coupon, which is a fixed interest rate paid regularly, in addition to the return of their initial investment amount when the debt matures. The yield of a bond is its expected return, and higher yields mean lower prices, since the bond is paid back at par when it matures. Selling bonds allows the issuer to fund expansion, normal business operations, or exceptional expenses, without giving up an ownership stake in the company. External analysts at ratings agencies assign issuers and individual bonds a credit rating, which indicates the ability of the issuer to repay the debt. Investors normally deal exclusively in investment grade bonds, which meet a minimum standard for creditworthiness. Non-investment grade bonds, sometimes known as junk bonds, have a greater risk of default, and are not typically traded except by specialist investment funds. Bond investors can be long term, using these assets as a hedge against volatile equity markets, or short term, including day traders.

Why are bonds important?

Bonds are important because of their role as investment assets and because of their function in the broader economy. For traders and investors, bonds offer multiple benefits; the most important of these are diversification, income generation, capital preservation and their ability to act as economic indicators. Diversification is probably the main use of bonds for retail investors. Bonds can help balance a portfolio heavily weighted in stocks, such as the average retirement portfolio. They provide both a hedge to equity market movements, since high grade bonds are a risk-off asset, and a steady income stream through coupon payments. Due to its nature, investors often allocate more and more of their portfolio to bonds as their retirement date approaches, usually highly rated government bonds such as British Gilts.

Types of bonds

Bonds can be categorised into groups according to their issuer, type of issuer, and creditworthiness. There are also some bond types – such as zero-coupon bonds, or convertible bonds – which are rare and aimed at specialist investors, and so not considered in this article. The most important types of bonds you will come across are government bonds, corporate bonds, municipal bonds, and high-yield bonds. The vast majority of retail bond trading involves the first two categories, but understanding all four will help you trade better in fixed income markets.

Government bonds

Government bonds are issued by national governments. In most cases, these are considered a low-risk asset, sometimes a safe haven asset when issued by the largest national economies. For example, the yield on short-dated US government treasury bills is considered the ‘risk-free rate’, since the theoretical risk of a default is zero. Bonds of smaller countries or emerging markets economies may be higher risk, with some poor and heavily indebted countries having very low credit ratings. The prices of government bonds fluctuate according to interest rates, the economic performance of the national economy, and global market movements. Government bonds are characterised by the issuer, and the time frame. For example, German government bonds are divided into short term Schatz, medium term Bobl, and long term Bunds.

Corporate bonds

Corporate bonds are issued by private companies to fund their business operations. The rating and price action of the bond depends on its issuer – large, stable companies will have higher rated bonds with lower coupons. By contrast, small, new, or struggling companies will have higher coupons and yields. As a general rule, corporate bonds have higher yields than government bonds, due to their higher coupons. Bonds with higher coupons compensate traders for taking on more risk; it is more likely a company will go bust than a nation state. However, some very large multinational companies issue bonds which investment characteristics closer to government bonds. This is not surprising when you consider that Apple has annual revenues similar to the national GDP of South Africa or Hong Kong.

Municipal bonds

Municipal bonds are issued by local governments, and typically have higher yields and lower credit ratings than government issued bonds. The USA is the best known market for municipal bonds, but they are issued in many other countries worldwide including India and the UK. These bonds fund the expenses of local governments, for example state, district or city governments. Because these units are far smaller than national governments, they have a greater risk of default and accordingly must pay higher coupons to investors.

High-yield bonds

High-yield bonds, also known as non-investment grade or junk bonds, have credit ratings below a certain threshold. Not all of them default, but many might or will. Accordingly, they have far higher yields, both because they trade under par and also because they offer very high coupons to attract investors. Retail investors are cautioned against these bonds, as they have an enhanced risk of default. When a bond defaults, the price falls to 0, or sometimes slightly above zero as investors fight over potential claims to remaining assets.

Popular fixed income trading strategies

Day trading bonds is very different to other assets, since they are redeemed at par, representing the initial value of the bonds issued. Prices fluctuate around a par of 100, which indicates the value which was originally invested and will be paid back at maturity, assuming the issuer does not default. Bonds may trade above par, decreasing their yield, if there is great market interest in it and buyers drive up the prices. Bonds which trade more than a few cents below par are at risk of default, with investors moving out of the debt instrument as they are concerned about the issuer’s ability to repay. When the market value of the bond decreases, yields increase.

Bond trading strategies

Traders active in fixed income markets rely less on technical analysis than forex or stock traders, and more on fundamental and credit analysis. A few common strategies include yield curve trading, where traders try to profit from changes in the relationship between short-term and long-term interest rates, and credit spread trading. In credit spread trading, bond traders exploit differences in yields between bonds with different credit qualities. Another common bond trading strategy is speculation in interest rates. Bonds and interest rates have an inverse relationship, so when interest rates rise, bond prices fall, driving yields higher. That makes speculation about changes and interest rates one reason to trade bonds.

How does bond trading work

Bonds are traded on decentralised over the counter (OTC) markets, unlike stocks and shares. Bond market hours vary from location to location; in the US, bond trading occurs between 8AM and 5PM EST. Trading bonds via CFDs allows ADSS bond traders to access global bond markets, and speculate on price movements in fixed income markets without taking ownership of the underlying asset. CFDs also offer leverage on bond trading, which can allow you to profit off the relatively small moves in these markets. Remember, bond CFD holders do not receive coupon payments – instead, CFD bond trading is based off price changes as fixed income assets fluctuate around par.

Conclusion: is trading bonds for me?

Knowing how to trade bonds effectively requires a solid understanding of economic principles, including interest rate dynamics, and risk management. While bond trading can offer opportunities for steady income and capital gains, it also comes with risks. Before beginning trading bonds, consider your investment goals, risk tolerance, and the time you can dedicate to monitoring the markets. Remember, successful bond trading often requires patience and a long-term perspective. Whether you’re interested in trading bonds for hedging, to diversify a stock portfolio, or speculation, it’s crucial to educate yourself thoroughly and possibly start with a demo account to practice your strategies risk-free. With the right knowledge and approach, bond trading can be a valuable addition to your investment toolkit.

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