Besides forex and stocks, bonds are another popular class of securities that attract many investors. In fact, bonds are traditionally a core component in many types of portfolios, most famously in conservative strategies designed for long-term performance.
However, it doesn’t mean that investors with shorter time horizons should overlook bonds – with advanced trading methods, bonds can produce results over the short term as well.
This article will explain what bonds are, how they work and how they are traditionally positioned in an investment portfolio. We will also explore different ways you can trade and invest in bonds.
What are bonds?
Bonds are a type of debt securities, and are issued by government bodies, private companies and other organisations as a way to raise funds.
Investors who buy into the bond essentially make a loan to the party issuing the bond. In return, the issuer of the bond promises to pay back the full loan amount by a stipulated date. The issuer also provides fixed interest payments on the loan.
Known as the coupon rate, this interest (aka dividends) is paid out at regular intervals, ranging from monthly to once a year. However, bonds commonly pay out dividends every quarter.
Like all investments, bonds are subject to risk – specifically, default risk and interest-rate risk.
You see, as bonds are basically a type of loan, the bond issuer may fail to repay the loan at maturity, creating a risk of default. When this happens, investors may not be able to get their money back.
Incidentally, bonds issued by governments (including municipal and treasury bonds) are generally regarded as having lower default risk, whereas corporate bonds are seen as having higher default risk. However, this is not always true.
As for interest-rate risk, this pertains to the inverse relationship between bond prices and prevailing interest rates (i.e., the cost of borrowing set by central banks, such as the U.S. Fed).
In short, bond prices fall when interest rates rise (and vice versa), which means bondholders face devaluation of the bonds in their portfolios. Hence, bond investors have to be aware of their exposure to interest-rate risk.
Advantages of Trading Bonds
Bond trading offers several advantages to bond investors, making them an attractive investment option. Firstly, bonds provide a reliable source of income. When investors hold bonds until maturity, they receive regular interest payments, which can be helpful for those seeking a steady cash flow.
Additionally, bonds offer the potential for principal preservation. At maturity, bondholders receive the full principal amount back, along with the interest earned, making bonds a relatively safer investment option compared to stocks .
Another advantage of trading bonds is the diversification they bring to an investment portfolio. Bonds have a low correlation with other asset classes, such as stocks . This means that when stocks may be experiencing volatility, the performance of bonds can help stabilise the overall portfolio returns.
By including bonds in their investment portfolio, investors can mitigate risk and achieve a more balanced portfolio. However, do bear in mind that the credit rating of the bond is important in determining the bond quality and credit worthiness.
Understanding Bond Markets
The bond markets are where bonds are traded and act as the primary platform for bond issuers to raise capital. There are two primary types of bond markets:
#1 The primary market
The primary market is where new bonds are initially sold. When companies, governments, or other entities want to raise money by issuing bonds, they do so in the primary market. This is usually facilitated through auctions or with the assistance of investment banks. Investors can participate by purchasing newly issued bonds directly from the issuer. The primary market offers a variety of bond types, allowing investors to find ones that align with their investment goals.
#2 The secondary market
The secondary market is where already issued bonds are traded among investors. In this market, investors can buy and sell bonds that were originally issued in the primary market. The secondary market provides liquidity, allowing bond investors to sell their bonds before they mature. It also lets investors buy bonds from other investors if they find them more appealing than newly issued ones.
What are Bond Coupons
Bond coupons refer to the periodic interest payments made by bond issuers to bondholders. It is an integral part of the agreement between the issuer and the bondholder, where the issuer promises to repay the loan (the principal) upon the bond’s maturity date and also make regular interest payments known as bond coupons.
The bond coupon rate is set at the time of issuance and determines the amount of interest that bondholders will receive. The frequency of coupon payments can vary, with options ranging from monthly, quarterly, or annually.
Understanding Bond Risks
There are also certain risks associated with bonds that investors should be aware of. The most common risk associated with bonds are:
#1 Default risk
This refers to the possibility that the bond issuer may fail to repay the bond at maturity. Government bonds, including municipal and treasury bonds, are generally considered to have lower default risk, while corporate bonds tend to carry higher default risk .
#2 Interest-rate risk
This risk is associated with the inverse relationship between bond prices and prevailing interest rates. When interest rates rise, bond prices typically fall, and vice versa. This means that bondholders may experience a devaluation of their bonds if interest rates increase.
Type of Bonds
There are various types of bonds available in the market. Some of the common types include:
These bonds are debt securities issued by the government to raise funds for various purposes. These can include financing public projects, covering budget deficits, or managing the national debt. When an investor purchase government bonds, they are essentially borrowing money to the government.
Corporate bonds are issued by companies to raise funds for their operations or expansions. When investors purchase corporate bonds, they are essentially lending money to the issuing company. These bonds typically offer higher returns than government bonds, but as mentioned earlier, they also come with a higher risk of default.
These bonds are debt securities issued by state or local governments. The funds raised through municipal bonds are utilised to finance public projects and infrastructure developments, such as constructing schools, hospitals, and other public facilities.
Treasury bonds, also known as T-bonds, are issued by the government to cover expenses and manage national debt. They are considered very safe investments because the government guarantees repayment. These bonds are backed by the government’s full faith and credit, making them among the safest investment options available.
How are bonds related to stocks?
When discussing portfolio strategy, bonds are often mentioned in the same breath as stocks. You may have heard of the popular “60% stocks-40% bonds” rule of thumb, which is widely recommended as a conservative investment allocation.
This is because the bond market tends to move in opposition to the stock market, as bonds are generally less volatile (and hence, lower risk) than stocks.
Hence, when the stock market is falling, an inverter may sell off stocks in anticipation of a price drop and buy up bonds instead. When the stock market is rising, the opportunity cost of holding bonds (which do not fluctuate in price as much as stocks) becomes far higher, encouraging investors to sell bonds and buy stocks instead.
This, of course, is an overly-simplified explanation, but it forms the basic premise for the popular practice of buying into both stocks and bonds to diversify your portfolio and hedge against risk.
Bonds Trading Strategies
If eligible, retail investors may purchase bonds directly from a bond issuer, such as a government body or private company. For example, in the US, federal bonds are issued by the Department of the Treasury.
Many government and corporate bonds are commonly reserved for hedge funds, pensions and other institutional investors only. However, once issued, bonds may be freely traded on the secondary market – this represents an opportunity for retail investors to get in on the action.
Retail investors can purchase bonds through an online brokerage that offers them. Be aware that buying a bond on the secondary market after issuance may mean having to pay a different price than the bond’s face value – this will impact the yield you receive. There will also be sale charges, commissions or fees, as levied by the online brokerage.
Similarly, you may also sell your bonds on the secondary market through a broker. If you sell at a higher price than paid, you will make a capital gain. Otherwise, if you sell at a lower price, you will make a loss.
You can also choose to hold the bond to maturity, whereupon you will be paid the face value of the bond. You would have also collected any coupon payments you were entitled to.
Bond Exchange Traded Funds (ETFs)
Both directly subscribing to a bond at issuance and buying a bond on the secondary market after issuance, entails direct ownership of specific bonds.
For those that prefer not to hold bonds directly or want to diversify across multiple bonds instead of choosing just a few, there is a third option.
Bond ETFs are investment funds that track the performance of specific segments of the bond market. They strive to offer yields that are close to the coupon rate of the underlying bonds, although there will always be a slight difference due to the management fee charged.
Unlike individual bonds, bond ETFs do not have maturity dates, as fund managers constantly rebalance underlying holdings. However, they do provide monthly dividend payments.
Importantly, bond ETFs offer higher liquidity to investors, which means you may find it easier to sell your bond ETFs holdings when desired.
Why invest in bonds?
Potential passive, long-term returns
Because bonds are debt instruments that pay fixed dividends, they are well suited to providing passive returns. You will receive any coupon payments you are eligible for as long as you are holding the bond.
Furthermore, bonds are available in a variety of durations, ranging from 2 years all the up to 30 years. This makes bonds – especially the ones with longer durations – suitable as a means to derive a fixed income stream.
Potential for capital gains
Because bonds are allowed to be traded on the secondary market, this opens up the potential for bond traders to trade them.
Just like with stocks, an investor can create trading opportunities if they sell their bonds for a higher price than when they bought them.
However, recall that bond prices are influenced by interest rates, which means it may be comparatively more difficult to work out an optimal time to sell bonds, compared to stocks.
Further complicating matters is the tendency for the open bond market to run into liquidity issues during market turmoil, potentially preventing bondholders from making time-critical transactions.
Speculate on bond prices with CFDs
Contracts for Difference (CFDs) offer a way for traders to avail themselves of opportunities in the bond market, without having to purchase bonds or own bond ETF shares.
With CFDs, there is no direct exposure to individual bonds or bond funds. Instead, traders can speculate on price movements in the bond market, and may potential benefit or lose in accordance with whether the price moves as predicted.
Additionally, CFDs allow traders to start investing in bonds with lower capital, instead of having to put up the full price of the bond. CFDs can also be executed using leverage, allowing investors to amplify the outcomes of their trade (whether for better or worse.)
Trade popular bonds with Vantage today
Bonds are traditionally favoured for their ability to provide long-term fixed income. But with advanced trading tools, the bond market can offer potential short-term price action.
Vantage offers unfettered access to the most popular bonds available today through CFDs. Trade leading bonds at a fraction of actual bond prices, diversify your trades with the freedom to go long or short.
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- “Some Advantages of Bonds – Investopedia”. https://www.investopedia.com/investing/bond-advantages/. Accessed 3 July 2023.
- “The Benefits of a Bond Portfolio – Investopedia”. https://www.investopedia.com/articles/bonds/08/bond-portfolio-made-easy.asp. Accessed 3 July 2023.
- “Corporate Bonds: An Introduction to Credit Risk – Investopedia”. https://www.investopedia.com/investing/corporate-bonds-introduction-to-credit-risk/. Accessed 3 July 2023.