Besides forex and stocks, bonds are another popular class of securities that attract many investors. In fact, bonds are traditionally a core component in many types of portfolios, most famously in conservative strategies designed for long-term performance. However, it doesn’t mean that investors with shorter time horizons should overlook bonds – with advanced trading methods, bonds can produce results over the short term as well.
This article will explain what bonds are, how they work and how they are traditionally positioned in an investment portfolio. We will also explore different ways you can trade and invest in bonds.
What are bonds?
Bonds are a type of debt securities, and are issued by government bodies, private companies and other organisations as a way to raise funds. Investors who buy into the bond essentially make a loan to the party issuing the bond. In return, the issuer of the bond promises to pay back the full loan amount by a stipulated date. The issuer also provides fixed interest payments on the loan.
Known as the coupon rate, this interest (aka dividends) is paid out at regular intervals, ranging from monthly to once a year. However, bonds commonly pay out dividends every quarter.
Like all investments, bonds are subject to risk – specifically, default risk and interest-rate risk. You see, as bonds are basically a type of loan, the bond issuer may fail to repay the loan at maturity, creating a risk of default. When this happens, investors may not be able to get their money back. Incidentally, bonds issued by governments (including municipal and treasury bonds) are generally regarded as having lower default risk, whereas corporate bonds are seen as having higher default risk. However, this is not always true.
As for interest-rate risk, this pertains to the inverse relationship between bond prices and prevailing interest rates (i.e., the cost of borrowing set by central banks, such as the U.S. Fed). In short, bond prices fall when interest rates rise (and vice versa), which means bondholders face devaluation of the bonds in their portfolios. Hence, bond investors have to be aware of their exposure to interest-rate risk.
How are bonds related to stocks?
When discussing portfolio strategy, bonds are often mentioned in the same breath as stocks. You may have heard of the popular “60% stocks-40% bonds” rule of thumb, which is widely recommended as a conservative investment allocation. This is because the bond market tends to move in opposition to the stock market, as bonds are generally less volatile (and hence, lower risk) than stocks.
Hence, when the stock market is falling, an inverter may sell off stocks in anticipation of a price drop and buy up bonds instead. When the stock market is rising, the opportunity cost of holding bonds (which do not fluctuate in price as much as stocks) becomes far higher, encouraging investors to sell bonds and buy stocks instead.
This, of course, is an overly-simplified explanation, but it forms the basic premise for the popular practice of buying into both stocks and bonds to diversify your portfolio and hedge against risk.
How to buy bonds?
- Direct subscription. If eligible, retail investors may purchase bonds directly from a bond issuer, such as a government body or private company. For example, in the US, federal bonds are issued by the Department of the Treasury.
- Secondary market. Many government and corporate bonds are commonly reserved for hedge funds, pensions and other institutional investors only. However, once issued, bonds may be freely traded on the secondary market – this represents an opportunity for retail investors to get in on the action. Retail investors can purchase bonds through an online brokerage that offers them. Be aware that buying a bond on the secondary market after issuance may mean having to pay a different price than the bond’s face value – this will impact the yield you receive. There will also be sale charges, commissions or fees, as levied by the online brokerage.
Similarly, you may also sell your bonds on the secondary market through a broker. If you sell at a higher price than paid, you will make a capital gain. Otherwise, if you sell at a lower price, you will make a loss.
You can also choose to hold the bond to maturity, whereupon you will be paid the face value of the bond. You would have also collected any coupon payments you were entitled to.
Bond Exchange Traded Funds (ETFs)
Both directly subscribing to a bond at issuance and buying a bond on the secondary market after issuance, entails direct ownership of specific bonds. For those that prefer not to hold bonds directly or want to diversify across multiple bonds instead of choosing just a few, there is a third option. Bond ETFs are investment funds that track the performance of specific segments of the bond market. They strive to offer yields that are close to the coupon rate of the underlying bonds, although there will always be a slight difference due to the management fee charged. Unlike individual bonds, bond ETFs do not have maturity dates, as fund managers constantly rebalance underlying holdings. However, they do provide monthly dividend payments.
Importantly, bond ETFs offer higher liquidity to investors, which means you may find it easier to sell your bond ETFs holdings when desired.
Why invest in bonds?
- Potential passive, long-term returns. Because bonds are debt instruments that pay fixed dividends, they are well suited to providing passive returns. You will receive any coupon payments you are eligible for as long as you are holding the bond. Furthermore, bonds are available in a variety of durations, ranging from 2 years all the up to 30 years. This makes bonds – especially the ones with longer durations – suitable as a means to derive a fixed income stream.
- Potential for capital gains. Because bonds are allowed to be traded on the secondary market, this opens up the potential for bond traders to trade them. Just like with stocks, an investor can create trading opportunities if they sell their bonds for a higher price than when they bought them. However, recall that bond prices are influenced by interest rates, which means it may be comparatively more difficult to work out an optimal time to sell bonds, compared to stocks. Further complicating matters is the tendency for the open bond market to run into liquidity issues during market turmoil, potentially preventing bondholders from making time-critical transactions.
Speculate on bond prices with CFDs
Contracts for Difference (CFDs) offer a way for traders to avail themselves of opportunities in the bond market, without having to purchase bonds or own bond ETF shares. With CFDs, there is no direct exposure to individual bonds or bond funds. Instead, traders can speculate on price movements in the bond market, and may potential benefit or lose in accordance with whether the price moves as predicted.
Additionally, CFDs allow traders to start investing in bonds with lower capital, instead of having to put up the full price of the bond. CFDs can also be executed using leverage, allowing investors to amplify the outcomes of their trade (whether for better or worse.)
