Bonds

Looking to strengthen your portfolio’s risk profile? Then investing in bonds could be a great option. For new traders, the market can seem complex, but bonds are relatively simple debt instruments. Our guide to swing trading bonds explains how they work, the merits and risks, plus the best online platforms.

The best bond brokers in 2024 include eToro, IC Markets and AvaTrade.

What is a Bond?

A bond is a fixed-income instrument. It represents a loan or an issue of debt that is converted into a tradeable asset. Bond agreements are usually issued by governments or corporations as a way to finance large projects. Owing to their municipal ties, they are relatively stable instruments, which in addition to their favourable interest rates and repayment plans, makes them an attractive investment proposition.

The bond market is the largest securities market in the world. In fact, it is one of the primary asset classes alongside stocks and forex. What is also special about the bond market is that it tends to move inversely vs interest rates. This is because a bond will trade at a discounted rate when interest rates are rising, and at a premium rate when interest rates are falling.

Unlike commodities or stocks, each bond agreement is unique. Specific details relating to individual bonds are outlined in a legal document known as an indenture.

Types

Bonds can be categorized into four classes:

• Corporate – issued by organizations, these are often used as an alternative to bank loans. Corporate bonds are popular because they tend to offer lower interest rates than traditional loans as well as more favourable payment terms.
• Government – also known as gilts in the UK, they are issued by government bodies. Bonds issued by national governments are also referred to as sovereign debt.
• Municipal – similar to government bonds, these are also issued by an authority, but this time at a local, rather than a national level.
• Agency – a security issued by a body or enterprise sponsored by a government.

Note, government and corporate bonds are the most popular and widely-traded options.

Issuers

Bonds are issued by governments and corporations as a way of borrowing money. An investor that purchases a government bond is essentially lending the government money. The same theory applies to a corporate bond, meaning the investor is lending a corporation money.

Bonds are often used to finance a range of projects from building new schools and roads to innovative community projects. Corporations can use bonds to finance large scale expansion or new research and development projects.

Trading Bonds

Bonds are usually issued at a par value of $100 or $1,000. However, the actual market price of a bond is dependent on a number of factors including duration, credit quality, coupon rates and interest rates.

Most are traded on public exchanges, however, some are traded on over-the-counter markets. Importantly, these markets operate without oversight from a central exchange. Some bonds can also be converted into shares.

Determining Price

The value of a bond is determined by its price and yield. The price refers to the sum it can be bought and sold at whilst the yield is the annual return if held to maturity.

The price of a bond will always move in the opposite direction of its yield. This is because the price reflects the value of the income generated through regular coupon interest payments. If interest rates fall, older bonds become more valuable because they were sold in a higher interest rate environment and therefore have higher coupons. The converse is also true, if interest rates fall, older bonds become less valuable.

Attributes

When it comes to trading, there is some key terminology to understand:

• Issue price – the price the bond is originally sold by the issuer
• Face value – what the bond will be worth at ‘maturity’. Face value is also used to determine interest payment rates
• Coupon rate – expressed as a percentage, this is the rate of interest the bond issuer will pay on the face value of the bond
• Coupon date – the dates outlined to make interest payments. Payments tend to be paid bi-annually but this can be flexible
• Maturity date – the date the bond matures and the issuer pays the bondholder the face value in full

Bond Trading Products

There are many different types available for swing trading:

• Fixed-rate – the most common type. These bonds have a coupon that remains fixed until maturity. Bond coupons can also increase over time which extends their duration.
• Zero-coupon – do not pay any interest. These bonds are generally issued at a discount to par value. The total principal sum is paid when the bond reaches maturity. U.S. treasury bills are a common example of a zero-coupon bond.
• Convertible – these give investors the option to convert the bond into stock should they wish to. Rates will depend on a number of conditions including share price. Convertible bonds combine both debt and equity characteristics and are therefore considered hybrid securities.
• Callable – similar to convertible bonds, a callable bond also has an ’embedded’ option. They do differ, however, in that a callable bond can be ‘recalled’ by the company or agency that issued it, and before it reaches maturity. If interest rates fall, a company might recall bonds back from bondholders and reissue new bonds at a lower coupon rate. Note, a callable bond is a riskier investment for buyers because of the risk of recall when the price is rising.
• Putable – gives an investor the option to put or sell the bond back before it has reached maturity. They are useful because they give investors an opportunity to get their principal back before the price falls. Putable bonds are considered more valuable and therefore tend to trade at a higher value.
• Green – issued by either governments or corporations to generate funds for projects that support environmental conservation efforts.
• High-yield – also referred to as ‘junk bonds’, they have a credit rating below BBB- on the S&P and Fitch scale and Baa3 on the Moody’s scale. There is a higher level of financial risk associated with these products which reduce their credit quality. These tend to have a high-yield relative to investment-grade bonds, to make them more appealing to investors.

Risks

There are two primary risks associated with swing trading bonds:

• Credit risk – refers to the risk that the bond issuer will be unable to meet principal and interest payments. Issuers are generally attributed a score based on their credit quality, which assesses their cash flow metrics against their debt.
• Interest rate risk – comprised of two parts: duration and convexity. Duration measures the sensitivity of a bond to changes in interest rates. Convexity measures the relationship between a bond’s price and yield as it experiences changes in interest rates.

There is a subtle difference between the two, but duration assumes that changes in interest rates and bond yields are linear. In reality, this is not always the case. Collective measurements can be used to quantify the uncertainty that changes in interest rates will have on the yield of a bond.

Pros of Trading Bonds

Bonds are attractive investment opportunities for several reasons:

• Yield pickup – many people choose to trade to increase the return or yield of their portfolio. The ‘yield’ is the return received if a bond is held to maturity.
• Stability – they are relatively stable investments. Bonds can be used as a relatively safe way to invest funds or manage risk across portfolios.
• Accessible – they are widely traded across global markets. There is also lots of variety within the types of bonds available.
• Leverage – margin trading is available at many top firms and platforms. They also lend themselves to multiple strategies with tighter spreads and low commissions.
• Research – rich corporate bonds data is easily available online, with information in secondary markets, trading volumes, electronic trading, treasury hours and more.

Cons of Trading Bonds

There are also drawbacks to consider:

• Stability – can be viewed in both a positive or negative light depending on your aims. If you’re looking to make big returns on drastic price swings, bonds are probably not the instrument for you.
• Liquidity risk – municipalities and corporations can suffer financial hardships. If a company goes into liquidation, the value of the bonds issued will likely fall. This, of course, can have serious implications for investors. As well as liquidity risk, bonds are also subject to credit risk, event risk, inflation risk and more. So whilst they are largely stable, they are not risk-free.

Final Thoughts

At first glance, the bond market can seem complicated. But, once you’ve got your head around the market dynamics as well as some basic terms and measurements, anyone can start trading bonds. They are a great instrument to diversify risk and are easily accessible at many top brokers and platforms.

Note, when comparing bonds vs stocks, equity trading or any other investment vehicle, consider your aims, strategy and trading experience.

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