Bond Trading 101: How to Trade Bonds

 

How to Trade Bonds

Open a bond trading brokerage account

While a number of online brokers offer very basic functionality to buy bonds, Chicago-based tradeMONSTER is a premier broker who has just launched a top notch bond trading platform with live streaming, two-way quotes on over 30,000 different bonds. You can open an account with tradeMONSTER by clicking here.

 

In addition, tradeMONSTER’s cutting edge technology offers depth of market (Level II quotes), easy bond search functions, ability to counter market maker’s prices and work orders. You can see a video overview of tradeMONSTER’s bond trading platform below.


How to find bonds to trade

The video below shows the different ways to find trading ideas


How to buy/sell a bond

The video below shows how easy it is to trade a bond.


What next?

Now that you know how to trade bonds, here is more information about bond trading.

 

Why trade bonds

  • Investment – Bonds are a way to invest cash as they provide interest income and capital gains.
  • Speculation – Like stocks, bond prices move up or down owing to a variety of factors
  • Market making – Traders earn spread by buying and selling bonds to other market participants.

 

What are bonds

We present a full chapter on bond basics in Debt Instruments 101.

 

How to choose what bonds to trade

You can consider the following criteria:

1. Names you are familiar with

Like in stocks you could choose corporate names you follow. Also under consideration will be government, agency and municipal bonds.

 

Bond Category Credit Quality Liquidity
Government Highest Highest
Agency High Grade Medium
Municipal High to Low Varies
Corporate High to Low Varies


2. Maturity

Short maturity bonds yield less since there is less uncertainty in the short term. Based on your investment view you can decide the maturity of the bond you wish to trade.

 

Maturity Yield Price Volatility
Short Lower Lower
Long Higher Higher


3. Liquidity

Each issuer may have a number of different bonds outstanding or varying maturity and coupon. Larger the number of bonds outstanding (Deal Size), the more liquid the bond. A more liquid bond will have tighter prices, more prices posted and larger trade-able size. Deals greater than $1 billion are usually considered liquid. Sometimes less liquid bonds may yield significantly more or less than similar bonds of larger deal size. This can present trading opportunities.

 

E.g. If Bond A and bond B differ only in deal sized (250mm vs. 1 billion) and bond A yields 4% while bond B yields 3.75%, a trader with a long time horizon, looking for investment income could choose bond A.

Similarly an existing owner of bond B, could do a switch trade into bond A.

 

Bond Yield Deal Size
A 4.00% 250mm
B 3.75% 1000mm

 

 

A few bond market practices to note

 

  • Bonds are typically quoted in multiples of $1,000. Hence 100 bonds have a principal amount of $100,000.
  • Prices are usually quoted as a percentage. So a price of 99.00 implies for every $1,000 of bond principal (notional), the buyer has to pay $990.
  • Interest is paid annually, semi-annually (most common), quarterly or monthly.
  • Proceeds of a bond trade = Price x Notional + Accrued Interest
  • Accrued Interest is owed to the seller as income for the period he/she held the bond. The buyer owes the seller the accrued interest upon settlement.
  • Credit Quality of bonds is broadly classified as

­   Investment Grade: Issued by corporations who are rated BBB- or better by S&P

­   Non-Investment Grade: Issued by Corporations who are rated BB+ or below by S&P

  • A bond is usually identified by its CUSIP. This is a 9 alpha-numeric characters long identifier that is universally to identify and book securities.

 

Factors that affect bond prices

 

Level of Interest rates: Bonds prices go up when interest rates go down and vice versa.

If a bond pays interest of 4% and interest rates go down to 1%, the bond becomes more valuable since it offers an above market yield. The price of the bond will go up. As the price goes up the yield on the bond will come down. The level of interest rates is primarily affected by economic data.

Credit Quality of Issuers: Like with stocks, the financial condition of the issuer determines extra yield traders demand for holding the issuer’s bonds versus a risk-free asset like US government bonds. This difference in yields is called the Credit Spread. This is generally higher for poor quality issuers, longer maturity bonds and subordinated bonds (owing to a lower place in capital structure).

 

Bond Maturity: Longer the maturity the higher the yield investors demand. Short term bonds have less uncertainty associated with them hence investors are willing to accept lower yields on them.

The difference between long and short term yields is the Term Premium.

 

Supply/Demand: When an issuer comes out with a new bond, its outstanding bonds may fall in price in anticipation of the supply. On the other hand bond prices may go up in anticipation of a buy back/tender offer.

Changes in these factors cause fluctuations in prices, presenting trading opportunities. Some of the event which affect bond markets are

  • economic data releases and related news e.g. a large increase in monthly non-farm payroll number would point to lower bond prices
  • geo-political events e.g. European debt crisis led to higher bond prices
  • stock market gyrations (usually bond prices increase when the stock market falls)
  • Federal Reserve rate announcements and speeches by members (an interest rate increase leads to lower bond prices)
  • bond issuance/tenders
  • corporate earnings releases and related news.

 

We discuss the above factors in more details below.

What Determines the Level of Interest Rates?

Poor data usually leads to lower interest rates and vice versa. For example currently the Fed has lowered interest rates to virtually zero owing to the extensive job losses, housing crisis and poor consumer sentiment. The Fed’s aim is to stimulate economy activity by lowering the cost of capital.

 

If the economy does well, interest rates will rise in expectation that demand for credit will go up. The Fed will have to raise interest rates to control asset prices and cool the economy.

 

The level of interest rates can be measured in many ways. One reference rate is yield on government bonds (like US Treasuries). Since Treasuries are assumed to have no default risk (the government can print money to make payments), they represent the risk-free rate of return (though treasury bonds are subject to other risks such as interest rate and reinvestment risk).  Treasury yields are affected by level of rates, bond maturity and shape of yield curve.

 

Non-treasury bonds have a fourth component, the credit risk premium, which we will cover next.

What Influences the Level of Credit Spreads?

All domestic bonds that are not US government issued contain some amount of default or credit risk.  This risk means that these bonds must compensate the bondholder for assuming this risk by providing a yield greater than what a Treasury security of the same maturity would pay.  This yield premium is known as the credit spread.

For example, if the 10-year Treasury note is yielding 5% and a 10-year AA rated corporate bond yields 5.75%, the credit spread of the bond is 0.75%. Bond traders simply refer to the yield of this bonds as “+75”.

The credit spread represents the market’s perceived creditworthiness of the bond issuer and will not only vary from one bond to another, but will fluctuate over time for the same bond.  The credit spread is calculated based on the current on-the-run treasury that is of the same maturity as the bond being considered.

The primary determinant of a bond’s credit spread is the bond’s credit rating.  However, not all bonds of the same credit rating and maturity will trade with the same credit spread.  Factors that can cause an issue’s credit spread to be larger/smaller than the credit spread of other issues of the same credit rating include:

  • A negative/positive outlook for the issuer’s industry group
  • A competitive disadvantage/advantage for the issuer
  • Expectations of a ratings downgrade/upgrade
  • A deteriorating/improving business or financial trend for an industry or issuer
  • An issue with less/more relative liquidity

 

You can read more about Credit Spreads here.

 

Bond Maturity

Longer maturity bonds will trade at higher yields compared to shorter bonds because:

  • They are more price-sensitive to changes in interest rates
  • They have a longer time horizon that presents more uncertainty as to the level of interest rates.

 

A popular way to take advantage of this is to do the “Carry Trade”. The idea is to borrow short term to purchase a longer-term bond that will pay a higher rate than the rate of the short-term loan.

 

Supply/Demand

Bonds are no different from any other asset with regard to supply and demand.

 

In the recent financial crisis investors flocked to US Treasuries as the safe asset to own. As a result they sold all other issuers (Agencies, corporate and Munis. Collectively known as Spread Product). This resulted in Treasury bond yields going down and credit spreads blowing out. Corporations had to issue bonds at very high yields despite the Fed lowering interest rates. All the demand was for safety.

 

As the fear of the crisis abated, the reverse happened. With the Fed keeping rates low, investors poured cash into higher yield alternatives which had cheapened up in the crisis. As a results credit spreads contracted.

 
 
 

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