Trading Bonds

How to trade bonds

One of the keys to trading and investing profitably is the ability to trade bonds when stocks aren’t performing well, and vice versa. Trading bonds is no different from trading stocks – the same rules of technical analysis still apply, and the same catalysts move bond prices as well. When the government reduces interest rates over a period of time, stocks often rise (as they are cheaper to buy, though the reason interest rates are being reduced may have a negative impact on their prices), the local currency falls in value and the price of local bonds rises. The important part is to understand what exactly you are trading, and how it is affected by the economic news around you. 

Bonds prices are often described by their % yield to maturity, rather than a dollar price. This indicates the return that you should receive if you held the bond until it matures, receiving the coupons that it pays and incurring any capital gains/losses that arise from holding the bond as it moves towards its fair value (often $100 or $1000) at maturity. What you see in the trading screen is a price that reflects that yield, however people normally refer to bonds by their yield rather than these prices.

Bond prices move in the opposite direction from the yields on the bond, and this inverse relationship is crucial to remember and understand. The reason for this is that you know the bond will end up at fair value (say $1000) at maturity, if the price of the bond falls, it will return a higher capital gain in between now and the maturity date. The coupon does not change. If you are making a higher capital gain, the yield to maturity on the bond must rise. Conversely, if the price of the bond rises, you will make a smaller capital gain (or you may incur a capital loss) between now and the maturity date, reducing the quoted yield to maturity.

What moves bond prices?

When stock markets are rallying and economic data is positive, bond yields are often higher as they reflect a higher cash rate set by the central bank. This means that bond prices fall when stock markets are rising, and therefore bond prices are more likely to rise when stock markets are falling. Many fund managers switch from stocks to bonds when they believe tough times are ahead, as they are looking for bond prices to rise more than stock prices, and you should consider doing so too. Sometimes switching to more resilient stocks just isn’t enough to prevent you losing money when the worst case scenario happens (think 2008), and its times like these that other assets such as bonds must be considered. 

In 2011 bonds outperformed stocks as investors poured their money into bonds, preferring stable coupon payments to the risky returns of the stock market. This drove up prices almost 10% for the year, easily outperforming global stock markets, and allowing astute hedge fund managers to outperform those that had only considered investing in different stocks. Take the time to do some more research into how and where to trade them, and no doubt there will be a time in future when you feel the time is right to seek better returns in the bond market.

In the pipeline: Why are bond yields low?

Bullish on: Australian stock market (has underperformed its global peers despite growing strongly)

Bearish on: US 10yr Treasury Notes (yields are still too low given strong stock market performances)

As always, please feel free to leave any comments or queries that you may have and I’ll be happy to answer them. If you are looking for more trading strategies, check out www.pimmtrading.blogspot.com.