The basics of bond trading for beginners
|What’s a bond?|
|Types of bonds|
|Common strategies for trading and investing in bonds|
If you're looking to invest, you might have come across bond trading. Well, here's a beginner's guide to tackling the fundamentals of bonds, what they are and how you can start building a strategy to trade them.
The bond market is the biggest market for securities in the world, and there are many ways to invest in it. Bonds were once seen as a way to earn interest on capital while safeguarding it. Now, they make up a huge global market that may offer many benefits to investment portfolios, such as the potential for high yields. So, before getting into the more complicated parts of this varied market, let's go over the basics.
What’s a bond?
The purchaser of a bond, also known as the bondholder, extends credit to the entity that first issued the bond. For example, when seeking funding, governments, corporations, and municipalities may resort to issuing bonds. And when a person purchases a government bond, they are effectively lending money to the government. In the same way, by purchasing a bond issued by a firm—otherwise known as a corporate bond—an investor effectively extends credit to that business. A bond is similar to a loan in that interest is paid on a regular basis and the principle is repaid at the end of the bond's term.
There’s always the chance that a bond's issuer won’t be able to make good on its promise to repay the debt in full, which is called "defaulting". It’s the job of independent credit rating services to analyze the default risk, or credit risk, of bond issuers and then publish credit ratings that help investors evaluate risk and help decide the interest rates on individual bonds. Typically, a lower interest rate is paid by an issuer with a higher credit rating compared to one with a lower rating. On that note, it's important to remember that investors who trade bonds with low credit ratings might have the opportunity to earn high returns, but they're also exposed to the added risk that the bond issuer would default on their payments. So, trade with caution!
Types of bonds
In terms of size, government and corporate bonds continue to dominate the bond market. However, mortgage-backed securities and other niche bond types provide important funding and investment functions in industries like real estate, for example.
As we mentioned earlier, you can think of a government bond as a loan to the government in exchange for a fixed rate of interest. Governments issue them to generate a budget for a slew of new projects, such as infrastructure. Meanwhile, investors use them to earn a steady return on their investments at predetermined intervals.
There is always some level of risk involved with every investment, but government bonds issued by financially secure countries are generally considered to be among the safest options. "Gilt" is the British term for government-issued bonds and U.S. government bonds go by the name "treasuries".
Provinces, states, and municipalities all issue bonds to raise money for infrastructure improvements and ongoing expenses like roads, bridges, and more. In the United States, municipal bonds are widely traded on the bond market. Municipal and provincial bonds are issued in other established global markets as well.
When it comes to the bond market, corporate bonds have traditionally been second only to government bonds in terms of numbers. To finance growth and innovation, corporations frequently tap the bond market for financing.
There are two major groups of corporate bonds, investment-grade and speculative-grade bonds (sometimes called junk or high-yield bonds). Corporations that issue bonds rated as "speculative grade" are seen as having worse credit quality and a higher default risk than "investment grade" companies. Since issuers' financial strengths can vary widely, corporate bond ratings span a wide spectrum within these two main groups.
Companies that are relatively new to the market, operate in highly competitive or volatile industries, or have fundamental issues are more likely to issue speculative-grade bonds. Higher payments on speculative-grade bonds are meant to compensate investors for the higher risk associated with buying these bonds due to their lower credit rating. If the issuer's credit quality drops, the rating could drop, but if the issuer's fundamentals improve, the rating could rise.
Emerging market bonds
Emerging market bonds refer to sovereign and corporate bonds issued by developing countries. Bonds issued by governments and corporations in both the U.S. dollar and the euro, as well as local currencies, have all contributed to the growth and diversification of the emerging market asset class for decades. What's more, emerging market bonds can help diversify an investment portfolio by providing exposure to a range of developing economies with varying growth prospects.
Mortgage-backed and asset-backed securities
Another important part of the global bond market is the securitization of the cash flows from different loans, such as mortgage payments, car payments, or credit card payments. Mortgage-backed securities and asset-backed securities are the two types of securitized investments that people trade most often.
Common strategies for trading and investing in bonds
Bond holders can choose from a number of investing strategies, each of which is designed to suit different objectives.
Investors interested in capital preservation, income, and diversification might find passive strategies appealing. However, these strategies don't wholly take advantage of changes in interest rates, credit, or the market. Buy-and-hold investing—which is holding onto bonds until they mature—and index-tracking bond funds and portfolios are two examples of passive investment strategies.
In contrast, active investment strategies aim to outperform bond indexes by purchasing and selling bonds to profit from fluctuations in the market. Success in active investing over the long run involves the capacity to generate data-backed forecasts about the economy, the path of interest rates and more to consistently outperform indexes. It's also important to have a firm grasp on bond trading in order to effectively act on your market analysis and keep your risk exposure in check.
1. Bond laddering
The term "laddering" refers to the practice of purchasing bonds of varying maturities to create a series of bonds with a wide range of potential returns.
There could be bonds with maturities of one, two, and four years in your portfolio. In order to keep the bond ladder going, you need to keep buying longer-term bonds with the money that comes from maturing bonds with shorter terms. It can be a helpful tool because it spreads out your exposure to fluctuations in interest rates.
Investors who purchase bonds with no immediate plans to sell are said to be employing the "buy and hold" approach. It refers to long-term investing because it "holds" onto the investment regardless of short-term market price swings.
This is a method of investing whereby the buyer bases their purchase decision on research into the company rather than on market speculation. Considerations such as the company's track record, its plans for future expansion, the variety and quality of its product line, and the efficiency of its management are all part of fundamental analysis.
Bond swapping is selling a losing bond, taking a tax deduction for the loss, and reinvesting the proceeds in a different bond with the expectation of a higher return. When you have a bond that isn't expected to recover anytime soon and other gains that you'd like to balance, this method might be useful. You can also use this strategy to buy a better or higher-yielding bond, which could help your portfolio as a whole.
"Barbelling" comes from the shape of the resulting portfolio, which is primarily made up of short- and long-term bonds with very few intermediate-term bonds.
All those short-term bonds mean that you'll have to keep making new investments. The long-term bonds in this strategy provide higher yields, while the short-term bonds provide greater liquidity. However, long bonds do carry interest rate risk and might lose value if rates were to rise, while short bonds would face less of a risk. When interest rates are stable, this tactic has the potential to be quite effective.
5. Active trading
When actively trading, you can employ a single strategy or a combination of them, with the ultimate aim of increasing your capital. Active investors will look for bonds that are now at a discount (and maybe distressed) but are expected to rise in value before they mature. To locate bonds with rising value, investors might evaluate the credit quality of particular businesses or macroeconomic variables. Although it is not recommended for inactive investors (armchair trading), this approach could potentially be successful in markets where volatility is low.