What Should You Know About Bond Trading?
Many of us are used to using borrowed money in some way to pay for our houses or cars via a loan or to buy smaller things thanks to money from friends and family. Similarly, companies, organizations, and governments also borrow money in different ways – one of which is by issuing bonds you can invest in!
Let’s discover bond trading in this article, so then you can maybe add them to your portfolio.
The bond market explained
When a company, government, municipality, or corporation wishes to raise capital for some reason, like a new project, expansion, or operational cash flow, for example, they might go to a bank for a loan, or they might issue bonds.
Bonds are similar to a type of IOU between a company and an investor. It’s a win-win arrangement that allows for the company to grow, and is a relatively low-risk and predictable investment for the lender.
The company issues its bonds for purchase, pays the purchaser a sort of interest rate, or what’s called a ‘coupon’, usually from one to four times a year over the length of the contract. When the length of that contract expires or ‘matures,’ the company pays back the entirety of the contract in full to the purchaser.
A bond is originally priced at what’s called ‘face value’ (sometimes called “par”) of usually $1,000 (sometimes $100) per bond. The asking price can be above or below this face value though once a bond is actually released to the primary marketplace. If the price is above the face value it’s called a premium. If the price is lower than face value it’s called a discount.
This asking price will affect the coupon rate you’ll be paid. Pay more for the bond and you’ll usually get a lower coupon rate. Pay less and you’ll get a higher one. Regardless of whether you secure a discounted or premium bond, you’ll be paid back the face value ($1,000 per bond) upon maturity.
If the bond is bought and sold prior to maturity it is sold on the ‘secondary market’ and this is where most traders take advantage of the bond market.
Some of the most widely known types of bonds include:
- Government bonds: this is a vast category of bonds that are generally backed by a central government. You also have local government and agency bonds in this bracket.
- Corporate bonds: companies looking to secure capital. Within this category, you might find speculative-grade bonds (high-risk junk bonds) and investment-grade bonds (lower risk).
- Emerging market bonds: generally, this is any combination of corporate and government bonds from developing nations.
- Mortgage-backed securities: these could be loans for a mortgage, car, or personal loans.
A few others to be aware of:
- Zero-coupon bonds: as it sounds, no coupons are paid until maturity. Higher risk, but potentially a greater payout at maturity.
- Variable-rate bonds: coupon rates that can change over the lifetime of the bond depending on prevailing interest rates or other selected variables.
- Fixed-rate bonds: as it sounds, the coupon rate is locked in until maturity.
- Convertible bonds: these can be converted from a bond to a stock.
- Indexed bonds: coupon payments are linked to a particular price index like an inflation indicator (CPI for example) and are adjusted for inflation for instance.
What influences the price of bonds?
While bonds are generally seen as less volatile when compared to stocks, they are still sensitive to certain factors for initial and ongoing pricing. Some of the major factors include the following:
The price of a bond is strongly influenced by the credit rating it’s given up at the time of issue, and this is published for public viewing in the financial and daily news. These ratings are evaluated by independent, private agencies such as Fitch Ratings, Moody’s, and S&P Global Ratings.
All rating companies have slightly different systems for rating bonds, but as a rule of thumb, AAA is the highest rating, a D rating often means the bond is in default, and a bond is not considered to be worthy of ‘investment grade’ status if it falls below BB+.
A lower rating can cause investors to feel the bond is riskier, and this will likely cause the price to move down, but once the price drops a certain amount, investors may feel this is now an attractive purchase again as the coupon rate has also increased.
The relationship between interest rates and bonds is inverse. Simply put, when prevailing interest rates go up, so do coupon rates and bond prices go down. When interest rates go down, so do coupon rates and bond prices head up. This happens because when interest rates increase, older bonds are less attractive than newer ones with higher yields.
You would be forgiven for thinking we’re talking about the length of time to maturity when we refer to duration here. Actually, it’s a formula that identifies the number of years it takes for the bond to pay back the purchaser by the bond’s total cash flows. It can also measure the bond’s price sensitivity to changes in prevailing interest rates. Typically, the higher the duration number, the more risk there is that a bond’s price will decline as interest rates increase.
Why might you want to include bonds in your portfolio?
Bonds are often included in portfolios as a means of diversification. They’re often seen as a stable and secure income-generating option, especially for those with a lower risk appetite and potentially less time until retirement.
They also offer a type of hedge against slowing economic conditions if the purchaser is also invested in the share market. When an economy slows down, eventually inflation goes down as well, and while this is rarely a good thing for shares, it generally is beneficial to the earning potential of bonds.
The type of bonds you intend to purchase will depend on your personal investment goals and your risk profile. It’s important to look at the specific terms of the bonds first, as they’re far-ranging in characteristics and there is a huge variety to choose from.
If you don’t want to directly invest in bonds, you can also buy shares of Bond ETFs. These Exchange-Traded Funds are exclusively focused on investing in bonds and you can choose different kinds of Bond ETFs, depending on your particular strategy and holding period.
Mistakes to avoid when investing in bonds
- Not knowing bond basics.
- Not following interest rate decisions.
- Thinking that bonds are not risky assets.
- Not spending enough time choosing the right kind of bonds for your risk profile and your objectives.
- Believing that holding bonds until maturity is the only way to trade bonds.
- Only focusing on yield rather than on other factors, such as diversification or duration.
- Ignoring other risks than the risk of issuer default.
- Placing too much emphasis on credit ratings.
- Overlooking the claim status of bonds.
- Not taking inflation trends into consideration.
- Not understanding all costs associated with bond trading.
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