Bonds, also known as fixed-income assets, comprise of the largest securities market across the globe, offering a wide range of investment options to investors. Such investment options include government bonds, corporate, and municipal bonds. Today, the value of the bond’s marketplace is estimated to be way above the $100 trillion mark. For most investors, bonds are an ideal way of earning steady returns at low risk. However, due to the ever-changing structure of the bonds market and products, investors can find it overwhelming to keep pace. It is, therefore, fundamental to understand the basics of bonds and the best approaches to bonds trading. This guide provides insights on how to trade bonds of various types.
What is a Bond?
A bond is defined as a loan given to the bond issuer by a bond purchaser. The bond issuer can be a federal government, state, municipal, or corporation. On the other hand, a bond purchaser refers to investors who lend money to the borrowing entity (issuer). In simple terms, investors who buy corporate bonds are ideally lending to the corporation in question; the same applies to investors buying government or municipal bonds.
How Do Bonds Work?
Like a typical loan, bonds pay investors a fixed-rate interest over a given period of time. After this period, the borrower repays the principal amount. The date within which the principal amount is repaid is known as the maturity date. On this date, the bond is said to have reached maturation. Following the existence of the secondary bonds market, most of the investors resell their bonds before they reach maturation towards the end of the loan period. The secondary bonds market is the avenue through which traders buy and sell bonds.
Different Types of Bonds
Generally, the bonds market comprises of three major categories of bonds, including the following;
Government Bonds – Government bonds are popularly known as Treasury bonds, referring to fixed-income assets issued by a central or national government. Examples of such bonds are the Gilts of the UK, Treasury Bills of the United States, and the China Government Bonds. These bonds are considered to be the safest in the market since they have no default risk.
Corporate Bonds – Corporate bonds are the second-largest fixed-income securities in the bonds market. These bonds are issued by companies and corporations to raise money for various business-related purposes, such as opening new product lines or financing business operations. Corporate bonds often come with a maturation period of at least one year.
Municipal Bonds – These are a category of bonds issued by cities, states, school districts, and other government-owned entities.
Benefits of Trading Bonds
Investing in bonds can be quite an exciting experience for traders, considering the many benefits that come with bonds. This segment addresses some of the benefits of trading bonds.
Generally, bonds provide investors with a steady flow of income,. This income is linked to the periodic interests issued to investors until maturation. Additionally, bonds have been known to offer predictable returns even during economic downturns. They behave differently than stocks that are usually affected by downturns. On the other hand, most bonds are safer to trade compared to any other class of assets. Mainly due to the fact they are secured against low or no default risk.
Unlike stocks that represent equity ownership in a company, bonds are debt. Typically, a bond investor (the debtor) is given a higher priority over a stockholder in a company’s capital structure. This means that in the event a company is liquidated out of bankruptcy, a bond investor will be paid ahead of a common or preferred shareholder. Investing in bonds, therefore, is usually safer than having a portfolio with substantial quantities of stocks.
Bonds, especially the high-yield fixed-income assets, are considered to have unique characteristics that distinguish them from other securities. Spreading bonds across various security markets, therefore, can help you minimize the risk concentration in one class of portfolio assets. For example, while stocks can experience impact on an economic downturn, bonds cam compensate the share losses.
Through economic cycles, the company in question (bond issuer) may experience an upward or increased revaluation of its bonds, stocks, or other fixed assets. Events causing such a scenario include acquisitions and mergers, improved earnings reports, rating upgrade, or even effective product development. Consequently, bond investors are rewarded with an increase in the value of their bond securities. This phenomenon known as capital appreciation.
How to Trade Bonds
When trading or investing in bonds, it is important that you know what the trading process entails. This step by step guide highlights the basic stages of the bonds trading process.
Acquire a Trading Platform
Like every other security, you will need a brokerage account for you to trade bonds. You are not obliged to trade by just opening a brokerage account. Some trading platforms may require you to deposit a specified minimum amount as per their policies for account activation.
Select Your Bond Type
Depending on your chosen broker, you will have access to a wide range of bonds. These include government, municipal, and corporate bonds. Notice that when trading bonds, you can sell or buy fixed-income assets from across the world freely. However, this might be the case when investing in bonds. This is because investing in bonds that pay in a currency different from yours exposes you to what is known as currency risk.
Decide When You Want to Open a Position
Once you have identified your ideal type of bond for trade, you will need to indicate the time around which you would want to open a position. Your success in trading bonds is significantly influenced by the time you schedule to open or close a trade. This timing is based on the premise of your speculation on the movement of bond prices. Most traders open or close a position based on their speculation on whether the interest rates of bonds will go up or drop.
Open a Trading Position
Through your brokerage account, you can initiate your first trade by opening a position. Opening a position means establishing a trade that will be active until its closure. This is also where you select your orders that bring a position to a closure when the prices move in favour or against you by several points.
Closing Your Position
If you have not applied such orders as a stop or limit orders, then your position will still be actively open. You will need to close the position yourself to cut down on losses or to leverage profits. A position is closed by making a trade opposite to what you applied to open it. For example, if you opened a position using a corporate bond, then you will want to sell the same amounts of corporate bonds to close it. You can calculate profits or losses by finding the difference in the opening and closing prices.
Bond Trading Sites
Today, there are plenty of brokerage firms providing investors with online trading platforms. The following are some of the best trading sites for bond investors.
IG, formerly known as IG Markets, is known for its outstanding brokerage services since 1974. Today, the company provides online bonds trading solutions to investors across the globe. IG is listed in the FTSE 250 index, with a market cap of over £3.1 billion. IG provides traders with a wide range of bond investments. These include other trading securities, such as forex and stocks. Other features that make IG market a unique global trading platform include the availability of trading courses for beginners, education materials, research tools, webinars, and customer service. You also do not need a minimum deposit to activate your IG account. Traders who withdraw a minimum of $150 on IG enjoy a zero-fee withdrawal transaction.
AvaTrade is another global leader in offering brokerage services for a wide range of securities. The company has a presence globally, with over 200,000 active users. Compared to other platforms, AvaTrade spreads are featured on average fees. All the trading fees are accumulated into a spread. As a result, the platform does not charge commission fees. You may be required to pay a minimum deposit of at least $100, depending on your trading security. Also, there are no withdrawal charges when withdrawing money from your AvaTrade account.
eToro is a bonds trading platform that is best suited for investors of all levels, including experts and beginners. In addition to convenient trading tools, eToro features a live account as well as a Demo account. The site also provides traders with a 1:30 leverage, which protects you from losing substantial amounts of money. The minimum deposit fee for your eToro account is $200. This amount may, however, be higher for investors outside Europe. The broker also has a trading app, advanced search functions, charting, and other features that enhance your trading experience.
Alpari was started in 1998, becoming one of the largest securities brokers across the world. They run various trading platforms, including the MT4, MT5, and Binary Trader. The trading platform is popular for the buying and selling of over 250 assets. Including two types of bonds, exchange-traded funds, and CFDs. Alpari provides the highest leverage in the market of 1:1000. In addition to the zero-fee minimum deposit requirement, investors trading on Alpari are given access to free research tools, trading courses, webinars, and other trading tools.
This is another trading platform that has performed well over the years as far as bonds dealing is concerned. E-Trade provides over 50000 product offerings from some of the best liquidity providers. E-Trade has no commission charges for new issue bonds and US Treasury bonds. However, traders will have to pay a commission of $1 for every other bond type. The trading platform is also known for featuring bonds tools, a resource centre, advanced screeners for bonds filtering, and other trading tools.
Risks Associated with Bonds Trading
Although the bonds market is safer than most of the other securities markets, bond traders are also exposed to various types of risks. Here is a highlight of risks and pitfalls associated with trading bonds.
Credit Risk – This refers to the risk that a bond issuer will be unable to repay the principal amount or period interest, hence defaulting. Consider examining the credit rating of an issuer before purchasing its bonds. Bonds with a D-rating are more prone to this risk than those with a AAA rating.
Interest Rate Risk – A rise in the interest rates of a given bond is a substantial risk for a bond investor. Increased interest rates result in a rise in bond prices, which means lower returns. Interest rate fluctuations should, therefore, be a concern for investors who are looking for high yields.
Liquidity Risk – This refers to the risk that an investor may be unable to find a buyer for their bonds, forcing them to lower the bond price below the market value. Recently issued bonds and government bonds are not significantly exposed to this risk.
Reinvestment Risk – A decline in the interest rates of the bonds market forces investors to reinvest their principal amount and coupon earnings below the current market rates. This is referred to as reinvestment risk.
Types of Metrics to Use When Considering Bond Investments
To mitigate the risks associated with bond investments, traders must be able to assess the sensitivities and downside of a given bond. However, it is impossible to establish a measure of such sensitivities and the potential performance of a bond without the right metrics. Here is an outline of the most common types of metrics used by bond investors.
Value at Risk (VAR)
You can use this metric to determine the occurrence ratio and extent of potential loss in an asset over a given time-frame
You may use this metric to establish the volatility of a bond by measuring the dispersion of a dataset from a specified average value
You can use this metric measure the sensitivity of a bond’s price relative to the underlying credit quality of the issuer
This metric measure the extent of which the capital price of a bond will fall before the capital losses outweigh the total income generated over a year of holding the bond.
Bonds provide investors typically with lower returns than other investments. However, their dependable returns and pricing stability make them attractive for investors aiming to get a higher level of security in their portfolio. An investment allocation in bonds can fit well with portfolio strategy of any investor.