Most people don’t know that much about bonds. Indeed, many investors shy away from investing in bonds since they find them confusing. However, for you to be a savvy investor, you need to understand the different investment platforms, and bonds happen to play a vital role in the economy.
Bond traders make money when they take a spread between the bond’s buying price and the selling price. When the buying price is lower than the selling price, they make money. Additionally, coupon payments accrued over time by holding bonds is the other source of income for bond traders.
This article will explain how bond trading works, how bond traders make their money, and how you can invest in bonds. You will also find out what to look out for when trading in bonds.
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Table of Contents
How Does Bond Trading Work?
Most people are quite familiar with the stock market, but did you know that the bond market is way bigger? Bonds are a crucial part of global economic markets—central banks worldwide use the bond market to conduct monetary policy.
Organizations and governments use bonds as a means of raising money. As an investor, you invest your money in corporate or municipal bonds. On their part, these entities agree to pay back your investment, with interest, over a given period.
For instance, if you buy a 10-year, $10,000 corporate bond at 3% interest, the corporate will pay you interest on the principal amount every six months. After ten years, you then get back your $10,000.
Bond trading is unique in that it does not occur in a formal exchange like the stock exchange. Instead, the bond market takes place “over-the-counter” or OTC market. This means you need to use a broker.
In general, bond trading can take place anywhere buyers and sellers agree. It’s also possible to trade bonds such as convertible bonds on the exchange.
When bond traders buy and sell their bonds, they specify the yield on the various bonds they are trading. This determines the price of credit in the country’s economy.
Bond Dealers and Bond Investors Explained
Bond trading takes place through bond dealers who sit on the bond trading desks of big-time investment dealers. Bond traders can still trade amongst themselves, though.
Bond dealers form a sort of intersection point and help create the bond market. As such, they:
- Offer bond investors liquidity, which makes bond trading easier
- Trade bonds with other dealers either directly or through bond brokers
- Connect with certain traders who gather information on all bonds, including their quoting prices
Apart from individuals, bond investors also include mutual funds, financial institutions, pension funds, and governments. Together with the dealers, these investors form the institutional market, which handles bonds worth millions, even billions of dollars.
In the retail market, individual investors trade bonds with investment dealers’ trading desks, although the trades usually fall under $1 million.
Types of Bonds
There are three main types of bonds. These bonds vary depending on the issuer, interest rate, risk level, and the duration until maturity:
- Corporate bonds: As the name suggests, corporate bonds are issued by corporates. One great thing about them is that their interest rates are usually higher than those offered by other bonds. However, unlike government entities, the issuing companies are more likely to default on a bond payment. A corporate bond’s risk level depends on the company’s creditworthiness.
- Municipal bonds: Local government entities, cities, and states issue municipal bonds to provide financing for public projects.
- Treasury bonds: Treasury bonds are also referred to as T-Bonds. The government issues these bonds. Since there is a low risk of default, T-Bonds interest rates are not as high as those offered by corporate bonds. Furthermore, you don’t need a broker with T-Bonds since you can buy them straight from the government.
How to Make Money as a Bond Trader?
In bond trading, the ultimate goal is to take a spread between the bond’s buying price and the selling price. Bond dealers or traders thus make money off the spread. However, they could also lose money.
As a bond trader, you can make money in either one of these two ways:
- You can decide to hold the bonds. Here, you hold the bonds until maturity and get to collect interest too. Bond interest payments are issued twice a year.
- You can trade them. You can sell the bonds at a price higher than what you paid for them.
Use the Bond Laddering Strategy
If you have bonds with differing maturity dates, you could also use the bond laddering strategy to make money. This is where you use the profit from bonds with short maturity dates to buy longer maturing bonds. This transaction is known as an income stream.
Use the Bond Swapping Strategy
If you are a skilled trader, then this strategy is ideal for you. In this case, you sell off a non-performing bond to get a tax write-off. Then, you reinvest the money you receive in high-yielding bonds.
Trading bonds entails speculating on price changes within a short period. As such, you only buy when you know your bond price will go up. Similarly, you only sell your bonds when you feel their price will drop. Hence, you make your money from the price movements.
One thing to note is that while the prices for equities are transparent, bond prices are not. As a result, bond brokers may exploit this feature and mark up a given bond price. This means that a broker could buy a bond at a low price, then resell it to an oblivious investor at a much higher price.
Luckily, the Financial Industry Regulatory Authority (FINRA) does its part to regulate the bond market by availing information on transaction prices.
What to Look Out for When Trading in Bonds?
If you are not buying your bonds directly from the underwriter, it would be difficult to tell whether you are making a good deal. This is more so if you are purchasing used bonds. So, what to do?
- Check out the company’s credit rating to determine whether it can honor the bond payment.
- Confirm the bond duration as this indicates how unstable the bond can get if interest rates were to change.
- When buying bonds from brokerages, confirm bond prices from available data or compare with bonds offering similar maturity dates.
Note that if a bond has an extended maturity date, it is prone to a higher fluctuation with a change in interest rates. Again, when interest rates go up, bond prices decrease. That’s the nature of bonds.
Disadvantages of Bond Trading
Bonds make one of the safest investments since their value doesn’t fluctuate much. They also provide you with a reliable income stream while offering you an opportunity to diversify your investments, thus reducing your financial risk.
Nevertheless, bonds still have their disadvantages:
- Bonds pay out a much lower return than stocks. Since you might not earn above the inflation rate, investing solely in bonds is not advisable when saving for retirement.
- Corporates can default on bond payments. Some companies could fail to meet their obligation to repay the principal plus interest. Therefore, it’s crucial to check a company’s credit rating before committing to buying their bond. Companies with a low credit rating tend to offer higher interest rates to attract investors. Such bonds are referred to as junk bonds.
- Bond issuers can exercise their early-redemption rights. If interest rates fall, bonds with call provisions allow their issuers to repurchase them before they reach maturity.
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Conclusion
Bonds are an excellent investment to add to your portfolio. Besides, trading bonds can enhance your profits. So, if you have not been trading in bonds, now is an excellent time to venture into this little-known investment platform.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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