An IOU-like debt security is called a bond. Borrowers create bonds to get money from investors willing to lend to them for a set time. When you buy a bond, you are lending money to the issuer, which could be a business, an organization, a municipality, or both. In exchange, the issuer agrees to pay you a specific rate of interest throughout the course of the bond’s existence and to refund the bond’s principal when it “matures,” or becomes due, after a predetermined amount of time.
Three major types of bonds exist
- Debt instruments, known as “corporate bonds,” are issued by public and private enterprises.
- Investment grade: Compared to high-yield corporate bonds, these bonds have a higher credit rating, indicating a lower credit risk.
- High-yield: These bonds offer greater interest rates in exchange for the higher risk because they have a lower credit rating than investment-grade bonds, which implies a larger credit risk.
- Municipal bonds, sometimes called “munis,” are debt instruments issued by counties, states, cities, and other governmental bodies. Various “munis” exist, including:
- The “full faith and credit” of the issuer, who has the authority to tax citizens to pay bondholders, serves as security for general obligation bonds, which lack any physical assets as security.
- Revenue bonds: Rather than being backed by taxes, these bonds are backed by the income from a particular project or source, such as tolls on the highway or lease payments. Some revenue bonds are “non-recourse,” which means that the bondholders do not have a claim to the underlying revenue source if the revenue stream disappears.
- Bonds issued by the government on behalf of private organizations, such as hospitals or non-profit universities, are known as conduit bonds. Typically, these “conduit” borrowers consent to repay the bond issuer, responsible for paying the bonds’ interest and principal. The issuer is typically not compelled to pay the bondholders if the conduit borrower misses a payment.
5 Reasons why investors trade bonds
Companies and other organizations, including governments, may issue bonds directly to investors when they need to raise capital for new initiatives, operations, or refinancing existing debts. Government and business bonds are frequently exchanged openly on exchanges.
The capital markets, meantime, are continuously in a state of flux. Interest rates have the potential to rise and fall. Prices for commodities can unforeseen soar or unforeseen drop. Booms and recessions come and go. Companies have the option to file for bankruptcy or recover after nearly collapsing. Investors frequently modify their portfolios before and in response to these occurrences to guard against or benefit from the shift in market conditions.
We will look at some of the most popular explanations for why investors trade bonds to determine where investors can discover opportunities in the bond markets.
Yield Pickup
The primary (and most frequent) purpose for bond trading by investors is to boost the yield on their holdings. Many investors aim to maximize the yield, the total return you may anticipate getting if you hold a bond until it matures.
What would you do, for instance, if you owned investment-grade BBB bonds from Company X that were earning 5.5% but noticed that bonds with a comparable rating from Company Y were trading at 5.75%? Selling the X bonds and buying the Y ones would result in a spread gain or yield pickup of 0.25% if you thought the credit risk was minimal. Due to the desire of investors and investment managers to maximize yield whenever possible, this trade may be the most popular.
Credit Upgrades trade
Fitch, Moody’s, and Standard and Poor’s are often the three companies that provide the most credit ratings for businesses and national (or sovereign) debt.
These credit-rating agencies’ assessments of the chance that a debt obligation will be repaid are reflected in the credit rating, and changes in the credit rating may offer trading opportunities.
If investors believe that a specific debt issue will soon be upgraded, they can use the credit-upgrade trade. When a bond issuer gets upgraded, the bond price often increases while the yield decreases.
The credit rating agency may increase a firm’s rating if it believes the company has become less hazardous and it’s financial standing and business prospects have improved.
By purchasing the bond before the credit upgrade, the investor in the credit-upgrade trade is hoping to capitalize on this expected price increase. But to execute this trade successfully, credit analysis skills are needed. Additionally, trades of the credit-upgrade variety frequently occur near the boundary between investment-grade and below-investment-grade ratings. A shift from investment grade to junk bond rating might bring about large rewards for the trader. Many institutional investors are prohibited from purchasing debt with a rating below investment grade is a major factor in this.
Credit-defense trade
Credit-defense trades are the following popular trade. Certain industries are more likely than others to default on their debt obligations during periods of rising economic and market instability. As a result, the trader might take a more defensive stance and withdraw funds from industries that are predicted to do poorly or where there is the greatest uncertainty.
For instance, many investors reduced their exposure to the European debt markets during the financial crisis that spread across the continent in 2010 and 2011 because of the elevated risk of sovereign debt default. This was a smart decision by traders who didn’t hesitate to exit as the crisis worsened.
Additionally, warning signs that a particular sector will lose money may be the impetus for starting credit-defense trades in your portfolio. For instance, more rivalry within a given industry (perhaps due to lower entry barriers) might result in downward pressure on profit margins for all businesses within that industry. As a result, some weaker businesses may be driven off the market or, worst-case scenario, file for bankruptcy.
Sector-Rotation Trades
Sector-rotation trades aim to redistribute capital to industries or sectors that are anticipated to do better than others instead of credit-defense transactions that aim to safeguard the portfolio.
Rotating bonds between cyclical and non-cyclical sectors according to your opinion of the direction the economy is headed is a popular sector-level approach.
For instance, many investors and portfolio managers switched their bond portfolios during the U.S. recession that started in 2007/08 from cyclical sectors (like retail) to non-cyclical sectors (consumer staples).
Those who took their time or were hesitant to exit cyclical sectors found that their portfolio underperformed compared to others.
Yield Curve Adjustments
A bond portfolio’s duration gauges how sensitive its price is to interest rate movements. In contrast to low-duration bonds, high-duration bonds are more sensitive to changes in interest rates.
For instance, a portfolio of bonds with a five-year maturity can be anticipated to fluctuate by 5% in response to a 1% change in interest rates.
Depending on your perception of interest rate direction, the yield curve adjustment trade adjusts the duration of your bond portfolio to obtain enhanced or decreased sensitivity to interest rates. Increase the bond portfolio’s duration in anticipation of a decline in interest rates because the price of bonds is inversely correlated to interest rates, meaning that a decrease in interest rates raises bond prices, and an increase in interest rates causes a decrease in bond prices.
For instance, in the 1980s, when interest rates were in the double digits, a trader may have expanded the duration of their bond portfolio in preparation for the reduction if they had known that rates would be steadily declining in the years to come.