How to Trade Bonds and Bond Trading Strategies - MagnifyMoney

How to Trade Bonds and Bond Trading Strategies

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While the bond market is trillions of dollars larger than the stock market, it often receives much less press. But there are plenty of folks 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.

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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: Interest rates and bond prices move in opposite directions. When interest rates decline, the prices of bonds that have already been issued rise. That’s because old bonds are paying more than new bonds, so old bonds tend to rise in value. The same is true when interest rates rise and already-issued bonds lose value.
  • 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.

If you want to refresh your memory on bonds, how they work and who issues them, we have a handy guide to bonds that’s a fast read.

Getting started: How to buy and sell bonds

If you want to get started trading bonds, you’ll need a brokerage account. You can buy bonds 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., including treasury bonds.
  • 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.

Regardless of the type of bond you decide to invest in, you’ll have to contend with commissions.

Trading commissions often run about $1 per bond, though volumes over $10,000 could earn you a discount. Brokerages 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 just buying one bond, you could pay up to 10 times more in trading fees than you might otherwise. If you’re making a small purchase, make sure you choose the right broker for the job.

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 rating agencies rate the bond.

It’s important 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. You’ll earn $50 annually for each bond you own. As the bond price rises to $1,250 (perhaps due to lower interest rates), its yield falls. That same bond still pays you the $50 coupon, but now the bond has a yield of 4% ($50 divided by $1,250). You 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.

On the other hand, 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 you the coupon of $50. However, its yield would rise to 6%, or $50 divided by $833. You 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 it until maturity, you’ll 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.

1. Buy and hold

With this strategy, you’ll buy a bond and hold it to its maturity date. It minimizes costs and is good for maximizing income (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

With laddering, you buy bonds with various maturities, building a “ladder” of maturity dates.

For example, you may have bonds maturing in one, three, five and seven years. When the one-year bonds mature, you extend the ladder by buying long-term bonds with the old bond’s proceeds. This strategy is low cost, smooths interest rate swings and provides an income stream. It can be a good strategy because it diversifies interest rate risk.

3. Barbelling

With barbelling, you buy mainly short- and long-term bonds and very few medium-term ones, so your portfolio looks like a barbell.

Because of all the short bonds, you’ll have to constantly reinvest. This strategy’s advantage 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 could suffer when rates rise. This strategy tends to work well when interest rates are relatively stable.

4. Swapping

This active strategy is like tax loss harvesting for bonds. When swapping, you sell a bond that’s losing money, 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, you may use one or several strategies, often with a goal of high capital gains. You’ll search for discounted (and sometimes distressed) bonds that will appreciate before maturity. You might 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 bond funds like ETFs and mutual funds, especially if you’re a beginning investor and have less money available.

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