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Bond Trading for Beginners (Updated 2019)

Last Updated: 22. August 2019
Bond Trading for Beginners (Updated 2019)
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Bonds make up 25 to 50 percent of a diversified investment portfolio, yet most investors pay little attention to boring old bonds. Because the average investor cannot easily trade bonds like banks and hedge funds do, many have settled for the reliable but low returns of government bonds.

The average investor no longer has to sit on the sidelines of the bond market. Fractional bonds known as minis and baby bonds are opening up the bond markets to all investors. ETFs, CFDs and futures are other ways the individual investor can trade bonds through an online broker.

Bonds are called fixed income securities because they pay a regular and steady interest rate payment to investors who lend money to governments and companies. Investment grade bonds are issued by governments and high grade corporate issuers, making them one of the lowest risk investments.

Why Trade Bonds?

Governments and corporations issue bonds to the public when they need money to finance their activities. Au business may want to open a new factory or a municipality may need money to build new roads. In exchange for lending the issuer money, the investor receives an interest rate payment on a regular basis over the term of the bond.

Many government bonds are virtually risk-free because these countries have never defaulted on a bond payment, but also low return.

Bond trading provides the opportunity to make higher returns on bonds. Some of the opportunities to make money trading bonds include:

  • Yield curve changes – Bonds trade at different yields (returns) based on credit quality. A bond with a lower yield could be sold and replaced with a bond with a higher yield.
  • Credit upgrade – An investor who anticipates a credit upgrade for a company could buy its corporate bonds at the current price with the expectation the bond will increase in value after the credit upgrade.
  • Sovereign debt crisis – If a country experiences an economic downturn or political turmoil, its bonds could be downgraded. This could be a good time to buy cheap bonds if you anticipate an economic rebound in the future.
  • Corporate credit change – A decrease in profitability owing to an economic downturn, cyclical industry downturn, or increased competition could result in a credit downgrade. Conversely, improved profitability could lead to a credit upgrade.
  • Price volatility – The day trader or speculator can trade the volatility from bond price fluctuations. Many factors affect bond prices, including interest rates and related monetary policy changes, corporate earnings, and economic reports.
  • Yield curve sensitive markets – Some industries such as financial services are very sensitive to changes in the yield curve (interest rates). If central bankers announce a gradual interest rate increase, banks can charge higher rates for loans and other products. The overall credit quality of the industry will improve.
  • Spread betting – Spread betting involves betting on the direction of a price movement of a bond or other security, without owning the underlying asset. A bet is placed based on a price per point movement. CFDs are a popular way of trading the spread on bonds or interest rates. It is illegal in the United States but legal in the UK and other European countries.
Portfolio diversification – Bonds and stocks have a negative price correlation and thus are the two main holdings of a diversified portfolio. A decrease in stock prices could be offset by an increase in bond prices, and vice versa. 

Pros and Cons of Bond Trading:

Pros

  • Principal preservation – pays back full face value at maturity
  • Fixed payments at regular intervals
  • Inverse correlation with stocks provides portfolio diversification
  • Very low default rate, and no default rate on investment grade government bonds

Cons

  • Lower returns than stocks
  • Mostly traded OTC among institutional traders
  • Lower liquidity in the secondary market
  • Limited or no bond investing provided by many online brokers
What are the other differences between bond trading and stock trading?

  1. Bonds have wider spreads.
  2. Execution is not instantaneous
  3. Not all bonds are available for trading.  A company might have 20 bond issues however, there might only be prices available for 10.

Types of Bonds by Risk Profile

The best uk bonds with high credit ratings are considered stable bonds with low investment risk. Bonds with low credit ratings pose a greater risk of default on interest payments and are therefore considered to be speculative investments. Generally, investment grade corporate and government bonds are considered low risk.

Corporate bonds – issued by companies with high credit ratings

Federal government bonds (treasuries, t-bills, t-bonds) – bonds issued by a federal government

Municipal bonds (munis) – bonds issued by a municipal government

Asset-backed bonds (ASBs) – Mortgages and real estate are two popular forms of asset-backed securities

High yield corporate bonds (junk bonds) – corporate bonds with low credit ratings

2. How to Trade Bonds on Margin

Ally has created a one-stop shop for financial products, including banking, auto lending, insurance and Ally Invest for your investment needs. At Ally Invest, you can choose a self-directed or managed portfolio investment plan. Bonds, stocks, ETFs and options can be traded at low fixed fees that decline as your trade volume increases. But why buy treasury bonds on Ally when you can buy direct from the government? Brokers allow you to buy stocks on margin. Here’s how.

You can now choose the treasury bonds you want to buy using your increased 1.5 leverage. Other options for buying bonds on Ally are bond ETFs and indices.

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3. How to Trade Bond Futures

IG is an LSE-listed broker licensed to provide over 16,000 markets across North America, Europe and Asia. With this global reach, IG is able to provide access to the world’s largest government bond markets, including US, UK, European, Asian and Australian bond futures, including the US Ultra T-Bond futures, UK Short Sterling, EuroBor and France’s Green Oat Bond – issued to finance climate change prevention and adaptation investments. IG provides a customizable trade layout and a wide range of indicators to accommodate both the professional and novice trader.

Under Find Markets, choose Bonds and MoneyMarket or Bonds and MoneyMarket – Mini. Mini futures contracts have revolutionized retail trading by providing retail traders access to fractional shares in contracts. IG CFDs offer minis of 20 percent the size and margin requirement of a standard contract. The popular US Ultra T-Bond futures at $10, for example, are available for $2 as minis. Then, choose the country you want to buy bonds from. We have chosen Europe.

Under European contracts, we have chosen the Eurobor-mini. You expect the European Central Bank to lower interest rates, which will increase the price of the Eurobar. The Eurobor-mini is currently trading at 10029.50. The June 2019 contract is priced at 10031.50. You could buy the contract outright today at 10029.50, or buy a mini-futures contract for a fraction of the cost. You purchase the mini-contract.

In June, the price has increased to 10033.50. You buy the contract at 10031.50 and make a profit of 2.00. Your actual profit would be the number of contracts you bought times the value per point of the Eurobar mini (20% of the standard contract $25 = $5). For one contract, the price rose 2 points, multiplied by $5 equals a gain of $10 per contract.

Had the September contract price fallen to 10029.50, you would still have to buy at this price, and therefore would realize a loss of 2.00. Conversely, if you expect bond prices to fall, you could sell a June futures contract for 10031.50. If the price falls to 10029.50, you make a profit of 2.00 points per contract.

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4. How to Trade Corporate Bonds


E*TRADE is one of the largest online brokers. The broker offers all types of bonds – government, munis, corporate and certificates of deposit. It also offers Baby Bonds, which trade on exchanges like stock. They are priced under $1,000 to be affordable to retail traders. There is no fee to trade US treasury securities on E*TRADE. Online secondary trading costs $1 per bond (min, $10) to a maximum of $250. Broker-assisted trades cost the offer price plus a $20 commission.

All available markets are listed in tabs across the top of the home page. Select Bonds to enter the Bond Center. Choose Corporate to trade the corporate bond market. Choose the industry.  You can also specify rate, maturity and so on. Use the bond calculator to determine the price and yield of bonds.

A large selection of corporate bonds is available. Assess the credit quality by reviewing the bond ratings. Research the company fundamentals as you would for a stock. Compare the rate being charged for bonds of the same credit quality.

Choose the bond you want to buy from the order book. Enter the number of bonds you want to buy. You may be asked for a CUSIP number (a serial number used to identify US and Canadian securities). Select Buy. After reviewing the trade order, click Place Order.

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Bond terms

Face Value – The face value is the amount the issuer pays the investor when the bond comes due at the date of maturity. Bond prices fluctuate. If you buy a bond for $1,000, you may receive more or less than the principal amount on the maturity date depending on whether the bond is selling at a premium or discount to the amount you paid.

Maturity Date – On the maturity date, the borrower pays back the face value of the bond to the lender. Bond maturities range from one to 30 years. You could sell your bond before the due date. Bonds as tradable securities can be traded on the secondary market.

Coupon Rate – The coupon is the interest payment you will receive through periodic payments (monthly, semi-annually or annually). Before finance went digital, bond holders would receive tear-off coupons to redeem for each interest rate payment due. Many government bonds pay coupons two times per year while corporate bonds may pay out two or four times a year.  Here is an example of the coupon rate for Microsoft’s corporate bond expiring in 2026.

Face Value    $1,000

Coupon          2.4 percent

Yield               2.9 percent

Payment        Bi-annually

This $1,000 corporate bond with a fixed coupon rate of 2.4% pays out $24 annually, or $12 two times per year.

Yield – The bond yield is the return the investor will receive on the bond expressed as a percentage.

Bond yield = Coupon payment / Face value of the bond

What are the Fees involved in Trading Bonds?

Following are fees you may incur when trading bonds.

  • Brokerage fees: Bond commissions are typically built into the bond price. A transparent broker should display the commission fee. Additional broker fees may be applied.
  • Overnight charges: A broker may impose a charge on every order that remains open by the end of the day, often referred to administration fees. This can be either a fixed charge or a percentage of the value of the trade.
  • Non-trading fees: These include withdrawal and deposit processing fees charged by the broker or the payment service provider.

FAQs

Are profits from bond trading taxable?

The income earned and investment gains on bond investments is taxable. The income earned may be deferrable until the maturity date. US treasury bonds are not taxable at the municipal or state level. Munis bought in your state are not taxable at the municipal, state or federal level.

What are bond futures?

Bond futures are a financial derivative of underlying bonds used to hedge against interest rate risk or speculate on the future direction of interest rates – Will they move up or down? The buyers and sellers enter into a contract to buy or sell a bond at a predetermined date and price. On the settlement date, they settle the difference between the contract price and actual price. Short- and long-term government bonds can be traded with futures contracts with four expiry dates a year.

Can I buy bond futures online?

Yes, bond futures are sold by online brokers and available to individual investors.

What is a savings bond?

Savings bonds are debt securities backed by the U.S. Department of the Treasury. They are issued electronically from TreasuryDirect.gov and interest is paid directly to your account. Series EE U.S. Savings Bonds have a fixed rate. Series I U.S. Savings Bonds have a fixed rate adjusted for inflation. Both have a maximum investment of $10,000 per year. Through an online broker, treasury bonds can be traded in the secondary market.

What are junk bonds?

Junk bonds are corporate debt securities with a credit rating of BB or lower. In exchange for accepting a higher risk of default, the bond pays a higher yield to investors. Because they are issued by companies in weak financial health, their prices can be volatile. Whether or not you invest in junk bonds, they can be a barometer of the overall financial health of the business sector. When junk bond issuance rises, it is a sign that companies are less creditworthy.

Are mortgage-backed securities high risk?

The 2008 Global Financial Crisis was triggered by mortgage-backed securities comprised of subprime mortgages of low credit quality. These debt securities must meet higher credit standards today. ETFs provide a low cost way for retail investors to invest and trade MBSs. The iShares Core U.S.

What is a bond ladder?

A bond ladder is a portfolio of bonds with different maturity dates. A portfolio, for example, may hold 10 individual bonds maturing one year apart. Three benefits of bond ladders are:

Interest rate risk diversification – Instead of being locked into one interest rate for 10 years, bonds will be renewed at the prevailing interest rate each year.
Regular income stream – As these bonds mature, the interest payments can provide an annual/semi-annual income for college, retirement or other purposes.
Compound interest – The bond principal (with or without the interest payments) may be reinvested in bonds to benefit from the power of compound interest.

If these investments are in government bonds, they may also provide untaxable income.

What is call risk?

Call risk is the ability of a bond issuer to recall a bond before its maturity. A 10-year bond bought in January 2019 with a coupon of 2.8 percent could be recalled when interest rates fall to 1.5 percent.

Are dividend paying stocks safer than bonds?

No. Bonds must always fulfill their interest rate payment obligations whereas a company can elect not to pay dividends, in less profitable years, for example. Bond returns are historically lower than those of stocks but less volatile. Because bond returns are more predictable, bonds provide a more reliable income.

 

Views expressed are those of the writers only. Past performance is no guarantee of future results. Trading comes with severe risk. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
Maggie Smith

Maggie is an investment expert with 10 years experience in dividend stocks and income investing. She has a PhD in Financial Markets and Investment Strategies and has contributed to a number of financial portals, writing stock market analysis pieces and reports on technology stocks and IPOs.

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