Bonds trading
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What is a bond?

 

Bonds are debt instruments that give the right to governments, corporations and municipalities to borrow money from institutional and retail investors, with fixed interest payments called coupons and until the pre-agreed maturity time that the bond will expire. Once expired, the borrower will return back the full amount (principal) received initially.

How are bonds performing today?

courtesy of TradingView

How are bonds performing today?

courtesy of TradingView

Bonds are securities that trade over the counter, unlike stocks and other exchange traded products. Traders buy bonds from brokers as an investment, with a plan to sell them in the future at a higher price, or as an income stream, from the periodic coupon (interest) payments that bonds generate.

 

Bonds are must have securities for well balanced and diversified investment portfolios. They come with risks though as with all investments. Traders should pay attention to the issuer’s rating, that classifies a bond as investment grade (high rated bond), as a high yield bond (junk bond), and other ratings in between. More on ratings here.

 

A key component of bond trading is interest rates that are adjusted by central banks, depending on inflationary pressures. Since bonds are debt instruments and pay interest (coupons), any shift on the prime rate can affect their price and evidently their yields. See image below.

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Bond terminology

When bonds are purchased initially, they are paid their face value also known as par value with the intention to receive semi-annual (usually) interest payments. That is until the bond reaches its maturity and the bond expires. Bonds can be traded through brokers at their current market value, that is affected by factors such as supply/demand and interest rates to name a few.

 

Bonds that cost in the secondary market more than their issued value are known to be traded at premium. The opposite goes for bonds trading at lower amounts than their face values, which are known to be traded at discount.

 

Yields denote the rate of return of bonds at any given time. Since the coupon is fixed while the bond price fluctuates, yields also fluctuate in a negative correlation to the bond prices.

The amount the bond is worth when it’s issued, also known as “par” value.

The interest rate paid on the bond. It never changes after the bond is issued.

The price of the bond in the secondary market.

The period remaining for the bond to expire.

The coupon of the bond divided by the current price.
Yield = Coupon/PV x 100

Total return if bond is bought today and held until it matures.
YTM = [Coupon + (FV-PV)/M] / (FV+PV)/2

Simplified example

TermsFace valueMV higherMV lower
Price (Market value)$1,000$1,100$900
Maturity10 years10 years10 years
Coupon (fixed)4% ($40)4% ($40)4% ($40)
Yield0.040.03630.0444
Yield to Maturity0.040.02850.0526

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Main bond categories / types

There are three main bond categories based on the issuer. The further we move from the private sector and into the corporate, the riskier the bond becomes. This being said, governments are known to default on their obligations as well. The three categories are Government, Municipal and Corporate bonds.

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Governments collect money from the public in the form of taxes. When this revenue is not enough to pay their expenses / to pay their current debt interest / to fund new projects or for operating cash flow, they issue bonds that everyday people can buy.

 

Government bonds are considered one of the safer investment options. The word “government or sovereign” should not be the sole factor in deciding to invest in this type of security. When taking into consideration the issuer (country), the investment can incur various degrees of risk. Economic conditions, levels of debt, national output, international affairs, can all impact the country’s ability to meet its obligations.

 

Some examples of government bonds are included in the table below:

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Other types of government bonds

NON-SOVEREIGN

These are issued by local but not national governments. These entities can include corporations, municipalities, states, and other non-sovereign entities. Non-sovereign bonds can be issued by private corporations, financial institutions, or government-related entities.

QUASI GOVERNMENT

Non-government bonds, backed by the national government - Government State Enterprises (GSEs). In the US, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation are examples that aim to increase the number of lenders.

SUPRANATIONAL

Issued by international groups. They usually comprise by two or more sovereigns to promote growth in their countries. The World bank is an example of a supranational entity. Other examples include the International Monetary Fund and the World Trade Organization.

It’s all about the yield

Bond investors look very closely at yields and how they impact the yield curve. Trading strategies can be developed with a yield curve outlook by understanding the central bank’s position on interest rates. Strategies can be further enhanced by reviewing the short Vs long term rates (also known as spread), making sense on the environment that can have a direct impact on bond yields, and being prepared for more than one outcome.

 

Strategies are always under revision and can be adjusted as the environment changes since the possible outcomes have already been anticipated. A quick example of trading the yield spread, could be buying the spread when there is economic expansion and the yield curve steepens.

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Under normal circumstances, bond holders get paid more interest if they buy long term maturity bonds due to the unpredictability of the long period. Short term pay less because they expire earlier. When there’s uncertainty in the markets, long term bond holders shift to short term bonds, causing the yield curve to flatten and then invert. If you can’t picture the chart, then think of the spread, the difference between the two yields. The closer the spread gets to 0, the flatter the curve. The second it goes below 0, you have an inverted curve.

 

Why is this important? Because inverted yield curves predicted every single recession over the years. If the inverted yield persists for a longer period, this would be yet another indicator that the economy is in a recession. Central banks take different maturities into consideration when looking at the yield curve, like the 2 year vs 10 year, or 2 year vs 30 year or an even shorter term like the 3 month T-bill.

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A municipality is a town / city or village of a country. It is a subdivision of the current government, it has regulations for it’s citizens and it’s governed by the municipal council and a mayor. Municipalities are a type of localized government, in contrast with the federal or state government.

 

Municipal bonds are an attractive option for individuals with high income due to the quality of the investment and the tax benefits associated with them. They are still prone to inflation risk, although they have been relatively stable during the Covid 19 pandemic and the 2008 great recession. Types of municipal bonds include general obligation, revenue and conduit.

GENERAL OBLIGATION
GENERAL OBLIGATION

Unsecured - the issuer has the ability to tax its residents to pay the bond obligations. Guaranteed payment from taxes and revenues of the municipality, rather than from specific projects

REVENUE
REVENUE

Unsecured - target is a specific project (bridges, toll roads, airports). They are meant to provide a future stream of income through infrastructure projects. If no income is generated , there will be no payment

CONDUIT
CONDUIT

Unsecured - funds raised on behalf of a private entity responsible for a project related to a public service such as hospitals, or low-income housing. They are exempted from federal, state and local taxes

Did you know? Municipal bonds are sometimes referred to as “munis” and historically, they have low default rates

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When private and public companies need funding to develop new products, funding for R&D, to finance a warehouse, or any other reason, they can issue corporate bonds. Depending on the company’s standing, the grade of the bond varies. The riskier the grade, the more interest it pays to compensate for it.

INVESTMENT GRADE

Bonds believed to have a lower risk of default, that are rated higher by credit rating agencies

HIGH YIELD / JUNK BONDS

Bonds believed to have a higher risk of default, that are rated lower by credit rating agencies

Second to government bonds, corporate bonds tend to see the most action. Corporate securities in general are sought after, since investors have multiple ways to hitch a ride on company performance. An investor can either be an owner by investing in stocks, or a lender by investing in bonds. Both types are very different in terms of risks, rewards and overall portfolio placement.

Did you know? In case of company liquidation, bond holders are the first to receive cash that becomes available in the process. Even before the company’s shareholders

Bond ratings

When it comes to rating bonds, the biggest names on the market are Moody’s and Standard & Poor’s.

 

The highest credit score for borrowers – be they companies or countries – is AAA. Both companies use the same designation for the very best, most reliable debtors.

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For more information on how ratings are achieved, please visit Moody’s or S&P Global.

Other bond types

Major economists have long been debating the credit cycles. Whether short term, known as small credit cycles, or long term known as big credit cycles, debt has always been measured against time and its relationship to economic output.

 

Powerful countries, must have advanced capital market systems with lending and borrowing capabilities to be able to fund all the things that make a country strong like education, innovation, technology, infrastructure and military. As such, there is a bond type for almost anything.

A word about the 2008 great recession and how a bond type triggered it

 

Mortgage-backed securities (MBS) were introduced in the 80s. These are packaged mortgages that produce a cash flow from different loans. They are securitized and sold to investors as bonds. Prime mortgages include borrowers with high credit scores, while subprime mortgages those with lower credit scores.

 

Housing prices were on the rise since the early 2000s. Low interest rates, pushed major banks like Goldman Sachs, Morgan Stanley and others into MBS, creating a bubble that no one expected to burst. In 2007, the US house prices started to fall, the economy started to decline, adjustable rates were going up in a way that people couldn’t afford and one institution after another (starting from Bear Sterns) was in need of a bail out, or collapsed altogether.

 

$700 billion was the final sum needed to prevent a domino effect with global repercussions. The subprime mortgage crisis was an eye opener to over leveraged products, reformed regulation and evolved financial products to avoid repetition of a financially catastrophic event.

Risks associated with bond trading

How to trade bonds?

Educate yourself

What are bonds, their structure, trading hours, CFDs

Bonds pricing

Symbols, bid/ask, pips, spread, price movers

Bonds logistics

Margin, margin call, stop out, leverage, lots, rollovers

Risk management

Stop loss, trailing stop, take profit, pending orders

Types of analysis

Fundamental, technical, sentimental analysis

Build trading plan

Trader types, risk tolerance, start small, pick direction, test

Choose a broker

Strict selection process, open a/c, KYC, funding, trade

Keep learning

Trading log, review, evolve, socialize, use technology

Test it all

Start with demo accounts, move to live but small

FAQs

Profitability, how to choose a broker, what to trade?

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Bonds can be traded by owning the underlying bond. This type of bond trading, is targeted towards retail investors that have a medium to long (buy and hold) strategy in mind. This being said, there are a lot of retail traders that take short term positions on the physical asset as well.

 

Bonds can also be traded through derivative products. These don’t involve ownership of the underlying bonds and are targeted towards short term traders that want to ride the price fluctuations with the goal of a quick profit. Examples include CFDs, futures and options.

 

Finally, traders and investors can gain exposure to bonds and bond types through basket products like funds and ETFs.

Pros of bond trading

Cons of bond trading

Income generation – the semi-annual interest payments, provide a steady stream of income to bond holders

 

Capital preservation – on maturity, bonds pay back the initial investment (face value) of the bonds, on top of coupon payments

 

Diversification – bonds have always been the counterpart to stocks in terms of portfolio balancing, providing a shock cushion

 

Tax haven – some bond types, especially government and munis can be tax exempt, or have low tax requirements for holders

 

A social investment – various types of bonds allow investors to take part in larger community initiatives like with munis

Transparency – Since bonds are not traded on exchanges, there is no standardized way to know that the best price is quoted

 

Returns on investments – bonds might be safer but tend to return less on the investment than other asset classes like stocks

 

Multiple price risks – bonds might be safer but tend to return less on the investment than other asset classes like stocks

 

Issuer’s financial standing – financial wellbeing of institutions (including governments) can sometimes change dramatically

 

Time until expiry – long term bonds are typically more prone to time risk due to the unforeseen events until maturity

Bonds FAQs

How do beginners trade bonds?

It’s always advisable to perform due diligence and adequate research on any security both as an individual security and as an asset class. Once this is done, a beginner can look into diversified portfolios of funds and ETFs investing in bonds. If a more direct investment is desired, government bonds as well as investment grade corporate bonds can be checked first.

How are bonds traded?

Bonds can be traded in the secondary market through broker-dealers. Apart from buying the underlying, there are derivative products like futures, options and CFDs, as well as pooled investments like ETFs and funds.

How do bonds provide returns?

Bonds pay periodically the coupon associated with them. This can vary depending on the bond, but it stays fixed throughout the life of the bond. At maturity, the lender receives the face value of the bonds held, which is why bonds are known for capital preservation.

Are bonds safer than stocks?

There is no one rule fits all when it comes to investments. The environment changes dramatically and where one instrument does well, another may suffer. Bonds do provide a cushion for any portfolio due to their income generation and capital preservation, as well as the relatively negative correlation to stocks. Bonds should always be looked into but with reservations as to the credit rating of the issuer as well as overall market conditions.

What is the biggest risk to bond trading?

We outlined a number of risks relative to bond investing. They are all important and carry their weight in the outcome of the investment. This being said, economic conditions that tend to shift interest rates (due to inflation primarily), can have an effect on all time frames of bond securities. Investors can get locked in bond investments if not careful, that can take a long time to even out, or might not even out at all.

Research and education is key

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