How to trade bonds

May 29, 2023

Bonds are one of the most popular financial assets, but if you’ve never explored what they are and how bonds work, you may have been put off by their reputation for being complex or a low-reward asset. 

In reality, bonds are a widely traded asset that can strengthen your portfolio’s risk return profile and add diversification without exposing yourself to excessive volatility. Their supposed low reward is balanced by being a low-risk, safe option for investors, and their inverse relationship to interest rates also offers some profitable opportunities for trading bond CFDs. 

In this article, we’ll break down what bonds are, what kinds are available for trading and how you can add this asset to your own portfolio, diversifying it beyond just stocks. 

What are bonds?

Bonds are, in the most simple terms, a type of debt instrument. Whereas individuals might approach a bank or credit union for a loan, companies and governments can raise capital by going to investors, who become bondholders in the organisation. Bondholders pay interest on the asset, known as a coupon rate, until the maturation of the bond — ‘maturity’ here being the due date when the initial loan amount (known as the principal) is repaid. 

Bonds are considered lower risk than other more volatile assets, but they do carry some risks associated with interest (coupon) rates, credits, defaults and prepayments. There are different types of stocks depending on what organisation, company or institution has issued it, but all are rated for their investment grade. 

What type of bonds are there?

Bonds can be both secured or unsecured. A secured bond protects the bondholder from the issuer defaulting on the loan, by pledging assets as collateral. Mortgage-backed securities are one example of a secured bond. 

Unsecured bonds, on the other hand, are not backed by any collateral. They are also known as debentures and are considered riskier assets because both the interest paid and principal are only guaranteed by the issuing company or organisation.

There are four kinds of bonds: 

• Government bonds — While some government-issued bonds are unsecured, they are considered to be some of the lowest-risk investments on the market, when the bonds are from stable governments that have never defaulted on a bond debt. In the US, government bonds are known as Treasuries, while in the UK, they are called gilts.
  
  Government bonds can be made available on both a fixed interest rate and with a variable coupon repayment that is tied to inflation. In the UK, inflation-linked bonds are called index-linked gilts, while in the US, they are called Treasury Inflation-Protected Securities or TIPS.
  
• Corporate bonds — Corporate bonds, as their name suggests, are issued by corporations. They’re used to raise funding for companies and, depending on the size and established nature of the company, they may be considered higher or lower risk.
  
  Corporate bonds are always higher risk than government bonds, but as a bondholder, you are afforded more protection from loss than an ordinary shareholder. For example, if the company goes bankrupt, liquidated assets are used to pay bondholders ahead of shareholders (this is known as a liquidation preference). Corporate bonds may be secured, and they are rated by agencies like Standard & Poor’s, Moody’s and Fitch Ratings, which assess their overall investment grade.
  
• Municipal bonds — Similar to government bonds, municipal bonds, or munis, are issued by municipalities, councils, cities and other local governments. They often have a lower interest rate and are considered less risky than certain other types of bonds.
  
  Municipal bonds may also be appealing to investors because they do not attract tax in the US.
  
• Agency bonds — Agency bonds are defined as securities, which are issued by government-backed enterprises or other federal government departments than the US Treasury. Largely a US phenomenon, they may be backed by the US government, as with the case of government department issued bonds, or not, as with those issued by government-sponsored enterprises (known as GSEs).
  
  Both the Fannie Mae National Mortgage Association and the Freddie Mac Federal Home Loan Mortgage bonds are examples of GSE bonds.

How do bonds work?

Bonds are simple debt instruments. They govern the process by which a bondholder loans money (known as the principal or face value) to a public or private institution (known as the issuer), and the issuer then repays this on an annual, semi-annual or monthly basis, as outlined in the terms of the bond. When the bond reaches maturation — its expiration date — the principal is returned to the bondholder. 

Because bonds are what’s known as negotiable securities, they can be bought and sold in a secondary market, in much the same way stocks are (although it should be noted that stocks and bonds function quite differently). Some bonds are listed on the stock exchange; however, most bond trading occurs through the use of OTCs (over-the-counter products) like CFDs (contracts for differences), which are traded through brokers. 

Like all debt instruments, bonds are heavily dependent on interest rates to determine their price. In general, interest rate hikes reduce the demand for bonds, as investors seek better interest rates elsewhere. In periods of decreased interest rates, the demand for bonds inversely increases, and their prices will rise. 

Bond characteristics

There are certain characteristics that set bonds apart from other assets and debt instruments. These are: maturation and duration, credit rating, face value and issue price and coupon rates and dates. 

• Maturity and duration — These two terms might sound interchangeable, but maturity and duration are actually different. The maturity of a bond refers to its active term, i.e. the length of time until it expires and its final payment is made.
  
  Duration, on the other hand, refers to both a period of time and a measure of a bond’s price sensitivity to changes in the interest rate. The Macaulay duration of a bond is the actual amount of time it takes to repay its principal, expressed as a number of years. The Macaulay duration is used to calculate a bond’s modified duration, because the longer a bond takes to pay off, the more vulnerable it will be to fluctuations in interest rates. The modified duration is the expression of that bond’s vulnerability.
  
• Credit rating — A credit rating essentially ‘grades’ all bonds on a scale of creditworthiness. As mentioned, ratings agencies are the bodies that produce these ratings — Standard & Poor’s and Fitch Ratings, for example.
  
  Credit ratings are useful to issuers because they can help to advertise a bond’s attractiveness to investors. Likewise, they are a valuable tool for assessing the risk of a bond for potential bondholders. Low-risk long-term bonds are given the highest possible AAA rating, while bonds assessed to be below investment grade are rated from BB+ (these are also known as junk bonds).
  
• Face value — The face value, or principal, is the amount an issuer agrees to pay to the bondholder, less any coupon (or interest) rate payments. Usually, the face value is paid at a lump sum at the expiration of the bond and doesn’t fluctuate in price from when it is initially set. There are some exceptions to this, such as TIPS (Treasury Inflation-Protected Securities), which are adjusted in line with inflation figures.
  
  Issue price should theoretically be the same as a bond’s face value, because both represent the full value of the loan. Where the issue price can differ, however, is on the secondary market, where the issue price of a bond can fluctuate significantly.
  
• Coupon rates and dates — The coupon rate, or interest rate, of a bond is the interest paid to bondholders, usually on an annual or semi-annual basis. It is also known as the nominal yield. The coupon rate is calculated by dividing the annual repayments of the bond by its full face value.
  
  Coupon dates govern the intervals at which these coupon payments occur. They can be monthly, semi-annually, annually or quarterly, but will be specified by the bond. 

What affects the prices of bonds?

The prices of bonds are subject to demand and supply, inflation rates, their credit rating and how close a given bond is to maturity. As we’ve discussed, bonds and interest rates have an inverse relationship to each other — when the price of one is high, the price of the other will be lowered. Demand for bonds is therefore dependent on interest rates and whether bonds represent an attractive investment because they are low or whether higher interest rates will tempt investors with better opportunities. If interest rates become too high, issuers may reduce the number of bonds on offer, in order to curb supply in line with demand. 

Credit ratings remain a strong indicator of a bond’s overall risk, and cheaper bonds will usually carry with them more risk of defaulting. It’s up to a trader how they decide to manage this risk, but credit ratings agencies remain a good guide for which bonds represent good investments. 

As a bond matures, its price will naturally return back to its face value, as the value of the bond reaches its initial loan amount. The number of coupon payments remaining on a bond will also affect its price. 

How do you trade bonds? 

Now that you know the ins and outs of what bonds are and how they work, it’s time to cover how to trade bonds. 

1. Choose the kind of bonds you want to trade. 

Both government bonds and corporate bonds are viewed as important elements of a diversified portfolio. Whichever of these bond types you choose to trade, a popular way to do so is with bond CFDs. CFDs are financial derivatives that work by deriving their value from speculation on the movement of a bond’s value, rather than relying on taking possession of the bond itself.

2. Pick your bond trading strategy. 

Bond CFDs, like all CFDs, are complex financial instruments. There are two broad approaches to bond trading strategies that you can take, but you can also do more research on other CFD trading strategies. 

The first strategy for trading bond CFDs is known as hedging. This is a loss mitigation tactic that involves trading in such a way that your gains and losses offset one another.

The second strategy is interest rate speculation. By correctly predicting the movements of interest rates, you can take a position on government bond futures via bond CFDs.

3. Open a bond trading account. 

You’ve decided on a bond CFD and a strategy; now you’re ready to get trading. To do so, you’ll need to create a live trading account. At VT Markets, you can do so in just a few minutes. If you want to practise your strategy before jumping into the live market, you can also create a risk-free demo account to put your approach through its paces.

4. Take your first position. 

Finally, you’re now ready to open and monitor your first position. Make sure you have the best trading platform at your fingertips. At VT Markets, we use the powerful MetaTrader 4 and its next-gen counterpart, MT5. 
Looking for more trading advice and tools? Feel free to contact our team today.