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Updated on Thursday, December 31, 2020
While the bond market is trillions of dollars larger than the stock market, it often receives much less press. But there are plenty of traders in the market trying to build their fortunes by trading bonds. Here, we cover the basics of how to trade bonds and explain some of the most commonly used bond trading strategies for the fixed-income markets.
- What is bond trading?
- Getting started: How to buy and sell bonds
- Understanding a bond quote
- 5 popular bond trading strategies
- Are bonds right for your portfolio?
What is bond trading?
Bond trading is the exchange of bonds among investors. By issuing a bond, a company promises investors to make interest payments of a certain amount for a specified time period. The art of bond trading lies in finding bonds that are going to increase in value.
What makes a bond’s value increase? There are at least two major things that do:
- Declining interest rates: This issue affects all bonds, though to varying degrees depending on factors like the bond’s maturity. When interest rates decline, the prices of bonds that have already been issued rise, and vice versa. That’s because old bonds are paying more than new bonds, so old bonds tend to rise in value. But it’s the reverse when rates rise, with old bonds falling in value as new ones pay more. The important point is this: Interest rates and bond prices move in opposite directions.
- A perception that the issuing company is less risky: All else equal, lower risk equals a rise in a bond’s price. That’s another way of saying that investors demand to be compensated with a higher return if they take on more risk. Risk can be lowered in many ways, such as improvements in the company’s business, the company debt payoffs, a general rise in the economy that is healthy for business growth — and the list goes on. In short, anything that makes the business less risky will tend to raise a bond’s price — so bond traders are looking to capitalize on these factors and others to find bonds that will reliably generate income and rise in price, resulting in a capital gain.
Getting started: How to buy and sell bonds
If you want to get started trading bonds, you’ll need a brokerage account. Bonds can be purchased through a specialized bond broker, though most online brokerages allow you to purchase them too. If you’re buying newly issued U.S. government bonds, you can buy them directly from the Treasury after setting up an account with TreasuryDirect.
Many organizations issue bonds, but some of the most popular types being traded on U.S. exchanges include the following:
- The U.S. federal government: This is the largest single issuer of bonds in the U.S.
- Corporations: These include companies large and small, domestic and foreign.
- Municipalities: These bonds are called “munis” and are issued by cities and counties.
- Foreign governments: These bonds are issued by foreign countries.
Between all the companies and governments — each with their own maturities and interest rates — that’s a lot of choice for an investor. In addition, it often takes at least $1,000 to buy a single bond, making it prohibitive for less well-heeled investors to get started and quickly build a diversified portfolio.
These concerns have led investors to increasingly turn to mutual funds and exchange-traded funds (ETFs) as a way to buy bonds. Funds trade with lower price tags while offering immediate diversification across a range of issuers. Plus, rather than analyze each bond individually, investors can easily and quickly select the kinds of bonds they want — whether they’re looking for funds with varying durations, a minimum credit quality of the issuer or other features.
Trading commissions often run about $1 per bond, though volumes over $10,000 may earn you a significant discount at some brokerages. Brokerages may sometimes roll up their costs in the bond price they quote you, making it less obvious what they charge. While some brokers have $1 minimum commissions, others have $10 minimums, so if you’re buying just one bond — already $1,000, typically — you could pay up to 10 times more in trading fees what you otherwise might. If you’re making a small purchase, make sure you choose the right broker for the job.
Trading commissions tend to be cheaper on municipal and federal government bonds, and some brokers will even allow you to buy U.S. Treasury securities commission-free.
Understanding a bond quote
When you buy or sell an individual bond, your broker will provide you with a lot of information about the bond. To make a smart trade, it’s important to understand what this info means:
- Price: This is the last traded price of the bond, often expressed as a percentage of the bond’s par value (defined as the price at which the bond was issued).
- Coupon: This is the bond’s payment, expressed in dollars (or the relevant currency).
- Yield: The yield is the coupon divided by the bond’s price.
- Yield to maturity: This is the yield assuming you hold the bond to maturity.
- Callable: This says whether the company can call the bond or force it to be redeemed.
- Duration or maturity: Essentially, this represents how long until the bond matures.
- Issuer: The company that issued the bond is known as the issuer.
- Bond rating: This is how the major ratings agencies rate the bond.
It’s vital to remember that a bond’s price and yield are inversely correlated. A bond’s coupon is typically fixed (though there are bonds that pay variable rates), so as a bond’s price rises, its yield falls. Investors receive the same coupon but are paying a higher price for that payout.
For example, let’s say a bond with a par value of $1,000 pays a 5% coupon. Bondholders earn $50 annually for each bond they own. As the bond price rises to $1,250 (perhaps due to lower interest rates), its yield falls. That same bond still pays the $50 coupon, but now the bond has a yield of 4%, or $50 divided by $1,250. The bondholder can sell the bond and realize the gain or hold and receive the coupon. In any case, the bond will eventually return to par value at maturity.
Conversely, if the bond falls below its par value, its yield will rise. For example, if the bond price fell to $833 (perhaps due to rising interest rates), the bond would still pay the coupon of $50. However, its yield would rise to 6%, or $50 divided by $833. The bondholder can sell the bond and realize the loss or hold and receive the coupon. The bond will return to par value at maturity.
However, it’s important to remember that if you buy the bond at par value and hold until maturity, you will receive the coupon indicated on the bond (assuming the issuer doesn’t go bankrupt). At maturity, you’ll also receive the par value of the bond, regardless of what you paid for it.
5 popular bond trading strategies
There are a number of strategies for trading bonds, ranging from relatively passive to active trading. Here are five of the most popular trading strategies.
1. Buy and hold
This strategy is as passive as it gets, with an investor buying a bond and holding it to maturity. It minimizes costs and is good for maximizing the income generated from bonds (as opposed to the capital gains), so it’s a good strategy if you need income but don’t need to sell the bond. However, your bonds will decline in value if interest rates rise, and it’s probably better not to sell at that time.
2. Bond laddering
Slightly more active than a buy-and-hold strategy, laddering involves owning bonds with various maturities. For example, an investor may have bonds maturing in one, three, five and seven years. When the one-year bonds mature, the investor extends the ladder, buying long-term bonds with the old bond’s proceeds. This strategy is also low-cost while smoothing swings in interest rates and providing an income stream. It can be a good strategy for investors because it diversifies interest rate risk.
This more active strategy involves buying mainly short- and long-term bonds and very few medium-term ones, so the portfolio looks like a barbell. Because of all the short bonds, you’ll have to constantly reinvest. The advantage of this strategy is that you get higher yields from the long bonds and flexibility from the short bonds. However, while the short bonds don’t have much interest rate risk, the long bonds do, and they will suffer when rates rise. This strategy tends to work well when rates are relatively stable.
This active strategy is like tax loss harvesting for bonds. When swapping, you sell a losing bond, get a tax write-off for the loss and reinvest in another (hopefully better) bond. This strategy can be good when you have a bond that’s not likely to recover soon, along with other gains that you might like to offset. You can also use this move as an opportunity to buy a better or higher-yielding bond — improving your overall portfolio.
5. Active trading
With active trading, an investor may use one or several strategies, often with a goal of high capital gains. Traders search for discounted (and sometimes distressed) bonds that will appreciate before maturity. Investors may analyze the credit quality of the individual business or macroeconomic factors to find bonds that are likely to increase in value. This strategy requires more advanced skills and active involvement — it’s not advisable for armchair investors, but it can work well in stable or normal markets.
Are bonds right for your portfolio?
Bonds offer some necessary diversification to your portfolio, especially if it’s already heavy in stocks. When stocks underperform, bonds move in the opposite direction and tend to offset those stocks losses.
Bonds also reduce the overall risk in your portfolio by providing some stability in comparison to the volatility of the stock market. However, younger investors should typically stray away from loading up on bonds: They have the flexibility to take on more risky investments with decades to go before retirement, allowing their portfolios to ride out the ups and downs in the market.
Finally, bonds provide a source of investment income — and who doesn’t love an occasional payout? Bond trading doesn’t get the same amount of press that stock investing receives, but it can still be lucrative without the potential losses associated with riskier stocks. Bond investing has become even easier with ETFs, especially if you’re a beginning investor and have less money available.