Bond Trading Explained: Choosing the Right Bond & More

Bond trading is the process of buying and selling government or corporate bonds (a type of debt contract) to receive interest payments and speculate on changes to the bond's value.

But how do bonds work? They are debt contracts between corporations or governments and regular people. Bonds enable anyone to loan money to an institution in return for receiving interest on top of their original loan after its duration.

Types of Bonds

Anyone learning the basics of bond trading must familiarise themselves with the various types of bonds. Each has unique characteristics like risk or yield and lends itself to different bond trading strategies. Some of the most popular types of bonds include:

Government Bonds

A government bond enables people to loan money to a particular government for a set amount of time, after which the loan is repaid with interest, referred to as a coupon payment. Learn more about what bonds are and their role in a portfolio.

Government bonds are some of the most stable and lowest-risk investments available, and typically have low yields. However, those issued by developing countries are considered higher risk than those backed by advanced economies like the UK or the US.

When trading bonds, it's essential to consider inflation rate forecasts and maturity time. If inflation outpaces a bond's yield, holding results in a loss instead of a profit. For example, if US inflation was 10% and a 5-year treasury bond yields 5%, the holder would effectively lose 5% of their investment yearly.

The online bond trading market is global; therefore, different countries use unique terminology. For example, a bond issued by the US government is called a treasury, but UK government-issued bonds are called gilts. US government bonds are the most popular, and there are a few different types:

1. Treasury Bills have an expiration date of less than one year.
2. Treasury Notes take between one and ten years to expire.
3. Treasury Bonds expire in over ten years.

Corporate Bonds

Corporate bond trading is similar in that people loan companies money, which is repaid with interest after the bond matures (when it expires). Coupon payments (the interest paid to bondholders) usually occur at regular intervals for a fixed amount.

Both corporate and government bonds are ranked on a bond rating scale. Credit agencies consider high-rated bonds low risk, while lower ratings signal a default or a high risk of defaulting (failure to meet their financial obligations).

While corporate bonds are popular, they're only as secure as the underlying company. Many factors can impact a business's ability to meet its obligations, so they must be considered before investing.

Bond ETFs

An exchange-traded fund (ETF) is a collection of assets like stocks, commodities, and bonds, typically sharing common characteristics like industry or nationality. Bond market ETFs are a popular investment vehicle offering stability, inherent diversification, and reduced risk.

Instead of directly purchasing a bond, traders can invest in a bond ETF, which contains multiple types of bonds, usually from different countries, sectors, or issuers. An example is the iShares TIPS Bond ETF (TIP), which invests in treasury bonds designed to protect against inflation.

Compared to purchasing a single bond, ETFs offer reduced risk and protection against a specific sector or country struggling. There are many types of bond ETFs, each targeting a particular market. For example, an international bond ETF provides exposure to many foreign governments or corporations.

Bond ETFs can be an excellent way of quickly getting exposure to multiple sectors. However, they can charge management fees, eroding the initial investment. Moreover, ETFs make it challenging to customise and fine-tune a portfolio, as investors cannot alter the fund's compositon.

Municipal Bonds

Municipal or muni bonds are another popular type of bond. Local governments or states issue them to raise capital for expenditures like schools, road maintenance, or libraries. They operate like other bonds, a loan that the issuer must repay with a fixed amount of interest.

Municipal bonds are often issued to pay for critical infrastructure in the local community. As such, they sometimes come with tax incentives, making them highly attractive to certain investors. An example of a municipal bond is the iShares National Muni Bond ETF.

Unfortunately, municipal bonds can cause confusion when filing taxes as some are except on a state/federal level, while others aren't. Moreover, it can be difficult to sell some muni bonds if they're infrequently traded and lack liquidity.

Other Types of Bond

While we've covered four of the most popular types, some other bond market examples include:

Green bonds are created explicitly for initiatives focusing on sustainability and social responsibility. They can be issued to help fund projects involving renewable energy, carbon capture, and sustainable agriculture. However, green bonds typically have lower returns due to higher issuance costs.

High-yield bonds offer larger potential yields, with the negative of high risk. These bonds are typically issued by companies with a credit rating below BBB.

Investment-grade bonds are any type of bond rated from BBB- to AAA. They are low-volatility bonds best suited to investments, as credit agencies have rated them low-risk. Generally, investment-grade bonds are stable and secure but offer lower returns compared to lower-rated bonds.

Cat bonds or catastrophe bonds are issued by insurance companies to manage financial risks and raise funds for disasters or catastrophic events like tsunamis. Holders earn interest but might have to forfeit a portion of their investment to cover damages if the event linked to the bond triggers.

Bond Trading Lingo

For people learning bond trading basics, familiarising yourself with common terminology is essential. Some of the most used bond trading terminology includes:

1. Principal - The original amount the trader purchased the bond for and the amount paid by the issuer after a bond matures. Otherwise referred to as face value.
2. Maturity - The date the bond expires, and the issuer must repay the loan.
3. Interest - The money a bond issuer pays in addition to the principal for borrowing money. It is usually expressed as a percentage and is otherwise called a coupon.
4. Coupon Rate - The annual interest rate the bond issuer pays to the bondholder.
5. Basis Points - A unit of measurement standard in finance. It describes the percentage movement of an asset. In the bond market, one basis point is equal to 0.01%.
6. Premium - A bond trading at premium prices has exceeded its principal or face value.
7. Discount - A bond trading at discount prices has fallen below its face value.
8. Bond Market Value - The current price of a bond, accounting for fluctuations.

Taxes on Bonds

How bonds are taxed depends on where you reside, how you profit, and the type of bond you purchase.

United Kingdom

In the UK, interest payments are subject to income tax, which is charged at the purchaser's tax band, which ranges from 20% to 45%.

Capital gains tax of 18% to 20% is also applicable if the bond is sold for more than it was bought for. People usually redeem UK government bonds (GILTs) at face value, but capital gains and income tax on interest still apply.

United States

In the US, income tax of 10% to 37% is charged on interest payments people receive. Likewise, bonds sold for a profit and held under a year are short-term capital gains taxed as income, while bonds held for 1+ years are taxed as long-term capital gains between 0% and 20%.

Some municipal bonds are subject to local tax but don't incur federal taxes. However, treasury bonds are subject to federal income tax but are exempt from state taxes.

Canada

Similar to the UK and US, Canada charges income tax ranging from 13% to 33% on interest payments, and capital gains tax applies to profits earned from a bond sale. However, only 50% of a person's capital gains are taxable in Canada. Canadian government bonds have no tax incentives.

Bond Trading Strategies

It's crucial to have well-defined bond trading strategies in place to protect your capital and improve efficiency. Some active bond trading strategies include:

Ladder Strategy

The ladder strategy involves purchasing bonds with mixed expiry dates. For example, 1, 3, 5, and 10 years. After a bond matures, the holder reinvests their capital in a new bond with an expiry at the far end of the range. This technique spreads risks and ensures consistent cash flow.

Barbell Strategy

The barbell strategy sees people purchase short (1-3 years) and long-term bonds (10 years) while avoiding mid-term options. Doing so allows the bondholder access to liquidity while benefiting from the higher yields long-term bonds offer.

Rolling Yield Strategy

The rolling yield strategy involves holding bonds for a short time and selling them as they approach maturity. It enables people to earn interest payments and profit if the bond rises in value.

Bond Trading Hours

Keeping track of bond trading hours is critical, as the market is only open from 8 am to 5 pm EST in the US, while the UK market trades from 8 am to 4:30 pm GMT. However, some institutions support continuous bond trading.

How to Trade Bonds with ActivTrades

ActivTrades offers a range of bond types, charting tools, and fast order execution. To trade bonds with ActivTrades, follow these steps:

1. Register with ActivTrades

Create and verify your account. You'll need to enter a name, email, password, and country of residence. Then, complete the verification process by providing details about your finances and employment. You'll also need to provide a phone number and your tax details.

2. Verify Account

After registering, verify your account by uploading a photo ID (passport, driving license, or ID card). You can upload a photo from a computer or mobile device.

3. Deposit Funds

Next, hit the green 'Deposit' button, choose a payment method, decide how much to deposit, and confirm the payment. The funds will arrive promptly.

ActivTrades offers the following payment methods:

1. Bank transfer
2. Credit/debit card
3. Cryptocurrency

4. Buy/Sell Bonds

Lastly, click 'Access Platform' under the 'Platforms' tab to open ActivTrader. Search for 'bond' or browse ActivTrades' supported assets, add them to your list by clicking the '+' icon, drag the tile onto the chart, press 'Buy' or 'Sell', input a position size, and press 'Place Order' to open the trade.

FAQs

How Do Bonds Make Money?

Investors can earn money with bonds via interest payments or by selling a bond for a profit. The bond issuer doesn't make money from a bond but uses the funds raised for a particular purpose.

Do Bonds Pay Dividends?

Bonds pay interest, known as coupon payments, to holders at regular intervals. The rate varies based on the type of bond, market conditions, and bond rating. Government bonds typically offer lower rates, while corporations with a poor rating tend to provide higher returns.

Are Bonds Securities?

Yes, bonds are debt securities, regulated debt contracts that can be bought or sold on secondary markets.

Are Bonds Riskier Than Stocks?

Although bonds carry an inherent risk, they're typically considered lower-risk, stable investments. However, certain bonds, like those rated BB or CCC, have a much greater risk of defaulting.

Should I Buy Bonds?

There is no set answer to this question. Whether someone should buy bonds is dictated by their personal goals and situation. Generally, people buy bonds to hedge against inflation or to reduce risk through diversification.

The information provided does not constitute investment research. The material has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and as such is to be considered to be a marketing communication.

All information has been prepared by ActivTrades (“AT”). The information does not contain a record of AT’s prices, or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information.

Any material provided does not have regard to the specific investment objective and financial situation of any person who may receive it. Past performance is not a reliable indicator of future performance. AT provides an execution-only service. Consequently, any person acting on the information provided does so at their own risk.