What is the bond market: useful information for novice traders

Not all newcomers know, but the stock market is not limited to stocks only. On it, there is another tool that investors often unfairly deprive of attention – these are bonds. What is this instrument, what are its advantages, and how to trade bonds profitably? How to choose the right bond, the yield of which will allow you to earn consistently? Let’s figure it out.

The role of bonds in the market

For successful trading, you should know what is bond market and what are the bonds, and what is the main difference in the bond market from the commodities market. According to the basics of trading, obligations differ mainly by who issued them. So, there are government bonds issued by a government agency – most often, the ministry of finance and treasury. These securities are considered the most reliable because unlike commercial organizations, the state will not go bankrupt, which means that the investor will be able to get money back on the bonds.

Also, there are municipal bonds – local authorities issue them in municipalities. Such obligations are also reliable.

The last type is corporate bonds, and commercial organizations – companies and enterprises issue them. This type of bond is considered the most profitable, but the risks here are also the highest.

What is bond market and bonds

On the stock market you can find both domestic bonds and securities of foreign issuers, for example, bonds of such states as:

  • US.;
  • Great Britain;
  • Japan;
  • Countries of Western Europe.

Bonds are also divided into discount and interest. Owning a refund online allows an investor to speculate in bonds and receive income from their resale at a higher price. Interest rates also will enable the investor to collect a fixed profit with a fixed frequency in the form of interest for the entire period of the bond circulation.

Classification according to time frames

By the way, according to the terms of the circulation period, bonds on the security markets are divided into short-term, medium-term, and long-term. Short-term circulation is a year or several months. Medium-term can be purchased for a period of 2 to 10 years. And long-term bonds can be purchased for 10-15 or more years. When any company is going to advertise its obligations, you should consider this factor before buying it.

The benefits of bonds

According to Google, a bond is a document confirming the social and economic organization’s debt to the investor and the obligation to repay the debt promptly. Thanks to bonds, mutual benefits of the parties are achieved, mutual funds are well distributed, and privacy policy is not violated.

  • the issuing organization receives additional funds or parts of them for development;
  • the investor receives a percentage of the invested amount while making his trading career;
  • in fact, for an investor, such an investment is like opening a deposit while making contact with a bank with all the necessary insurance, only with the right approach, the percentage of profit will be much higher;
  • the investor also benefits in that he can receive a stable fixed income, regardless of the situation in the stock and futures market or the market of real estate.

This is also beneficial for those who want to hedge risks and save their capital in difficult times without any credits and debts. The most important thing is to choose the right broker.

Key principles of working with bonds

Immediately worth mentioning one fundamental principle of working with obligations. The higher the potential return, the higher the risk of default and vice versa. Therefore, if an investor is planning a game with a large eye, he should bet on the reliability of all the data and not wait for lightning-fast profits.

In this case, he should buy securities with a fixed amount of payments – a coupon. This will allow you to have a stable business and not worry about raising or lowering the market value of bonds. However, at the end of the maturity period, such securities are redeemed at par, and if the bond were purchased at a cost higher than par, the investor would receive less than he invested. But the long-term investment is not the only option from the watchlist of working with bonds.

Combined investments

There is another option for combined investment when bonds and stocks are purchased in specific proportions, which ensures a 100% preservation of capital. For example, if the yield on bonds is 10%, then 90% of the funds are invested in them, and 10% in stocks. For the year, thanks to coupon income, the size of the deposit will increase by the amount of the initial investment, which will cover any possible losses from trading in shares.

Experienced advisors from the top rating of financial consults state that passive investing is an option for usually active traders who plan some break-in trading (for example, vacation). So that the money in the account does not lie without movement, the trader purchases bonds on them for the period he needs. Thus, while he will be inactive, his investments will be able to bring a small but fixed personal income.

Active trading

Another option is active trading or speculation in bands. Key Features:

  • a trader is looking for bonds that have recently fallen in price;
  • he buys them cheaper;
  • this makes it possible to earn on the subsequent growth of quotations and indexes;
  • in this case, functional analysis and control of interest payments are critical.

The reasons for the drop in quotes should not be fundamental. Otherwise, the trader will not buy bonds at the start of an uptrend, but on the verge of bankruptcy and retirement of the issuer.

How to earn money on bonds

To get a good profit on bonds, it is essential to choose the right bond, for example, the most popular ones- this is a crucial factor. The main requirements for the issuer:

  • the issuer must be reliable and must occupy a high position in the rating;
  • it should offer good yield on bonds;
  • he must not delay payments, including the taxes;
  • an essential condition is a good reputation in professional circles.

But the issuer’s right choice is not all that is needed for a profitable investment.

The importance of the economic situation

Let us consider the financial situation. Tirso predicts it, and you should read the news every day. The interest rate of bonds, and hence, the investor’s income, depends on the economic situation. If there are prerequisites for lowering the interest rate, it is worth giving preference to long-term bonds. Thus, you can make a profit on the growth of its value and record a high level of payments for the entire period of circulation.

If there is a reason to believe that the interest rate will rise, it is better to buy bonds with a maturity of six months to a year. So, you can protect yourself and your financial estate from big price swings.

Brief review of trading strategies

So, while buying bonds, the yield of which is higher than the payment of interest on bank deposits, you will already be in the black. And if you correctly combine your personal finance strategies, necessary options, and trading tools, including high tech tools, you can earn much more. To do this, you must have primary economic education, and also have a clear notion of bonds and ETFs. Also, you can study blogs of professionals on Facebook.

Shift and slope of the curve

With a change in inflation and mortgage rules, the likelihood of a real difference in the refinancing rate increases. If this happens, it turns upward, as it takes into account the growing yield of new bond issues. In anticipation of an increase in the curve, we sell bonds in circulation, which have more time to maturity, because in case of an increase in the rate, their price will fall compared to shorter ones.

The opposite is also exact: in anticipation of a decrease in the curve, we buy securities with a more extended period to maturity and sell shorter ones, since in case of a reduction in the rate; new issues will have lower profitability.

Spread to the curv

All bonds of one issuer should generally be on the same trajectory. This is because the selling less profitable bonds to buy more profitable ones knocks down the price of the former and raises the latter, which ultimately leads to a temporary equalization of returns in a small business. This is based on a simple strategy called the spread to your curve.

The essence of this strategy is as follows:

  • if for some reason some of the securities turn out to be briefly above the curve, they need to be bought until they have time to equal the others in profitability;
  • with a constant coupon, a decrease in yield occurs as a result of price increases, so you need to have time to buy cheaper;
  • conversely, assets below the curve sell;
  • subsequent growth in profitability is due to lower prices.

You can read about the most profitable strategies in newsletters sent by the companies.

The notion of modified duration

Suppose there are two comparable bonds, i.e., securities of one issuer and with the same length (the period required to return the funds invested in the bond). The yield spread between them usually varies within very narrow boundaries.

If for some reason, the spread narrows sharply, you should sell the bond whose profitability has abnormally decreased relative to the one being compared. On the contrary, with a sharp expansion of the spread, you should buy the one whose yield relative to another unusually sharply increased. Usually, use a scale on which 1% is equated to 100 basis points.

One of the reasons for the sharp fluctuations in the yield of a particular bond is that the sensitivity of the price to the yield spread is not symmetrical.

The price increase with spread is slightly more significant than a decrease with a negative range. Approximately this sensitivity can be described by a value called modified duration (MD). This is the derivative of the market price at the current coupon-free yield. It is directly proportional to the ordinary length and inversely proportional to the expected return to maturity.

Without going into mathematical details and details of the economy, you can interpret this indicator as a percentage change in price when 1% coupon yield changes. For example, if MD = 5 years, then a decrease in the return of 1% leads to an increase in the price of bonds by 5%. So, you should pay 5% more.

As a result, let’s say, lowering the refinancing rate, some bonds turn out to be as high as possible on the yield curve. This leads to a global increase in prices, and, as a consequence, a decrease in profitability. With other bonds that were closer to the curve, such jumps are not observed.

Useful advice

How to ensure a uniform cash flow over time? To do this, forming a portfolio of bonds, choose issues of one issuer, but with maturity, between which a constant interval is maintained.

At the next repayment, funds are reinvested in new purchases. For this, bonds are selected whose maturity period is later than the longest in the portfolio for a given interval. It is said that new releases add “to the tail” of the line. This strategy allows you to maintain a constant portfolio duration.

Posted: 2.07.2020 | Ludmiła Gorodnichenko
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