How to Trade Bonds
Bonds are units of debt issued by governments and major corporations, and they can be traded on various exchanges. Bonds are always considered a safe play for investors, who use them to guarantee both capital protection and profitability. Although investing in bonds is considered a low risk, low reward endeavour, their inverse relationships with interest rates open up lucrative opportunities for investors who wish to trade them in the CFD (contracts for differences) market.
It is important to understand how bonds work, before trading them. Here are the main terms to know when trading bonds:
- Issuer: The entity that issues the bond (government or corporation)
- Bondholder: The investor that buys the bond
- Coupon: Interest rate paid to the bondholder
- Maturity: The date the bond will be fully paid
- Par Value: The amount on which interest is paid (Principal/Face Value)
- Price: The prevailing price of the bond (usually expressed as a percentage of Par Value)
- Premium: When a bond trades at a price higher than Par Value
- Discount: When a bond trades at a price lower than Par Value
- Yield: The coupon divided by the bond price (it is the prevailing rate of return of the bond)
- Yield to Maturity (YTM): The total percentage a bond will return if held to maturity
- Bid: The amount an investor will pay for a bond
- Ask: The amount an investor will sell a bond for
- Spread: The difference between the bid and ask prices
When you invest directly in the bond market, you put the full value down with a bond broker and wait for interest payouts (usually semi-annually). You will be trading for the long term, hoping for the bond price and yield to rise. It is essentially a low risk, low reward, longer term play. This is very different from trading bonds.
In the CFD market, you trade bonds by speculating on their price changes both in the short and medium-term. Bond prices usually change marginally, but the leverage available in the CFD market allows for profits and losses to be simultaneously boosted. The relatively predictable nature of bond price movements means that CFD traders are exposed to market opportunities when tracking their preferred bonds or treasuries.
Bond Price Fluctuations Explained
To trade bonds effectively, you must understand why bond prices fluctuate. When you purchase a bond, you are essentially issuing a loan to a government or corporation. The loan pays a fixed interest, but the yield fluctuates depending on the price of the bond. The price of a bond can be at par, premium or discount. A premium bond is attractive to the issuer, but not to an investor, whereas a discount bond is attractive to an investor, but not the issuer. In other words, discount bonds will experience more demand, whereas premium bonds will witness more supply. Aside from supply and demand forces, bond prices can also be influenced by the credit quality of the issuer and the term to maturity.
The credit quality of the bond issuer is very important; this is why investors usually prefer bonds issued by governments in lucrative territories such as Japan, US and the European Union. Typically, an issuer with a higher credit quality can offer a relatively lower coupon initially, but the bond price will likely be at a premium during its lifetime. In contrast, an issuer with a lower credit quality will have to offer a higher coupon initially to compensate for the possible risk of default at maturity. The term to maturity or age of a bond has a significant impact on a bond price. At maturity, the issuer is expected to pay the bondholder the full principal amount. Thus, bond prices will tend to move closer to the Par Value as the maturity date draws near. The term to maturity also determines how a bond reacts to interest rates.
Bonds that are closer to maturity are less likely to be impacted by changes in central bank interest rates. But when there is a longer-term to maturity, bonds can carry a significant interest rate risk. Bonds usually have an inverse relationship to interest rate changes. That is, higher interest rates will trigger lower prices, simply because they make the prevailing bonds unattractive; whereas lower interest rates inspire higher prices because they make prevailing bonds attractive.
Bond Trading Strategies
There are two broad approaches to trading bonds: fundamental and technical. Fundamental strategies focus on qualifying the best bonds to trade for the medium to longer term. They basically allow investors to apply a passive buy-to-hold strategy. The biggest risk for a fundamental bond trader is liquidity. Therefore, fundamental strategies help eliminate bonds that will be difficult to sell when required due to low demand. Some of the major fundamental factors that will help you to pick out the best quality bonds include credit rating and other broader macroeconomic factors. Reputable rating agencies such as Moody’s and S&P usually give a score for various bonds available in the market.
Popular bonds, such as the Japanese Government Bond (JGB), usually have an A+/AAA rating, which implies a high-quality bond that traders can trade or invest in with confidence. Some of the macroeconomic factors to consider include metrics such as GDP, unemployment rate, trade balance and general market sentiment. Consistently positive numbers in a country or region make the underlying bonds more attractive to investors. In contrast, technical strategies help traders to take advantage of short to medium term prices changes in the bond market.
A common strategy is trading interest rates. Because bonds (particularly longer term to maturity ones) have an inverse relationship to interest rates, traders can take short to medium term directional plays when the underlying central bank communicates its monetary policy. There is also the yield curve play. The yield curve is a graphical representation of the relationship between interest rates and bond yields of different maturity periods. A typical yield curve has an upward slope, which implies that longer-term to maturity bonds yield more than shorter-term bonds. This is the ideal situation, and it signals a strong economy. However, a flattening or an inverted yield curve signals a weak economy because short term bonds yield more than long term bonds. Such a scenario usually signals that the underlying central bank will keep rates low or cut them further to stimulate the economy, a scenario that will influence bond prices and open an opportunity for bond traders.
All in all, the bond market is large and diverse, and the CFD market offers an exciting pathway to the potentially lucrative opportunity it presents.
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