What are the reasons investors buy bonds?

Investors buy bonds because: They provide a predictable income stream . Typically, bonds pay interest on a regular schedule, such as every six months.

What are the benefits of trading bonds?

As bonds are 'negotiable securities', they can be bought and sold in the secondary market. This means that investors can earn a profit if the asset appreciates in value, or cut a loss if a bond they sell has depreciated . Because a bond is a debt instrument, its price is highly dependent on interest rates.

Why would investors sell bonds?

However, by selling bonds after they have risen in price – and before maturity – investors can realize price appreciation, also known as capital appreciation, on bonds . Capturing the capital appreciation on bonds increases their total return, which is the combination of income and capital appreciation.

Why are investors attracted to the bond market?

Bonds have the added benefit of offering interest at a set rate that is often higher than short-term savings rates . Income: Most bonds provide the investor with “fixed” income.

Why do investors buy long term bonds?

Inflation can also reduce the buying power of the dollars invested in a 30-year bond. To offset these risks, all investors usually demand higher yields for longer-term maturities —meaning 30-year bonds usually pay higher returns than shorter-term bonds from an issuer or in any category.

What are three benefits of buying bonds?

Bonds tend to be less volatile and less risky than stocks, and when held to maturity can offer more stable and consistent returns . Interest rates on bonds often tend to be higher than savings rates at banks, on CDs, or in money market accounts.

What are the pros and cons of trading bonds?

Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures . However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.

Why do investors sell bonds before maturity?

Investors of bonds, however, may decide it is more advantageous to sell a bond rather than hold it to maturity. Some of these reasons include anticipation of higher interest rates, that the issuer's credit will be lowered, or if the market price seems unreasonably high .

Can you make good money trading bonds?

The second way to profit from bonds is to sell them at a price that's higher than you initially paid . For example, if you buy $10,000 worth of bonds at face value -- meaning you paid $10,000 -- and then sell them for $11,000 when their market value increases, you can pocket the $1,000 difference.

How do people make money trading bonds?

In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons . The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..

How do bond traders make so much money?

There are two ways that investors make money from bonds. The individual investor buys bonds directly, with the aim of holding them until they mature in order to profit from the interest they earn . They may also buy into a bond mutual fund or a bond exchange-traded fund (ETF).

Is trading bonds risky?

All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity . In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.

5 Reasons Why Investors Trade Bonds (2024)

When companies or other entities such as governments need to raise money for new projects, to fund operations, or refinance existing debts, they may issue bonds directly to investors.Many corporate andgovernment bondsare publicly traded on exchanges.

Meanwhile, the capital markets are constantly in a state of ebb and flow. Interest rates can go up, and they can go down. Commodity prices can unexpectedly surge and can unexpectedly crash. Recessions and booms come and go. Companies can declare bankruptcy or come back from the brink of death. In anticipation and reaction to these types of events, investors often adjust their portfolios to protect or profit from the change in market circ*mstances.

To see where investors can find opportunities in the bond markets, we will look at some of the most common reasons why investors trade bonds.

Key Takeaways

Investors trade bonds for a number of reasons, with the key two being—profit and protection.
Investors can profit by trading bonds to pick up yield (trading up to a higher-yielding bond) or benefit from a credit upgrade (bond price increases following an upgrade).
Bonds can be traded for protection, which includes being credit defensive, which involves pulling money from bonds exposed to industries that might struggle in the future.

1. Yield Pickup

The first (and most common) reason for investors to trade bonds is to increase the yield on their portfolios. Yield refers to the total return you can expect toreceive if you hold a bond to maturity, and is a type of return many investors attempt to maximize.

For example, if you own investment-grade BBB bonds in Company X yielding 5.5%,and you see that the yield on similarly rated bonds in Company Y traded at 5.75%, what would you do? If you believed the credit risk to be negligible, selling the X bonds and purchasing the Y ones would net you a spread gain or yield pickup of 0.25%. This trade may be the most common because of investors' and investment managers' desires tomaximize yield whenever possible.

2. Credit-Upgrade Trade

There are generally three main providers of credit ratings for companies and country (or sovereign) debt—Fitch, Moody's, and Standard and Poor's. The credit rating reflects the opinion of these credit rating agencies, on the likelihood that a debt obligation will be repaid, and the swingsin these credit ratingscan present a trading opportunity.

The credit-upgrade trade can be used if an investor anticipates that a certain debt issue will be upgraded in the near future. When an upgrade occurs on a bond issuer, generally, the price of the bond increases and the yield decreases. An upgrade by the credit rating agency reflects its opinion that the company has become less risky, and its financial position and business prospects have improved.

3. Credit-Defense Trades

The next popular trade is credit-defense trades. In times of increasing instability in the economy and the markets, certain sectors become more vulnerable to defaulting on their debt obligations than others. As a result, the trader can adopt a more defensive position and pull money out of sectors expected to do poorly, or those with the most uncertainty.

For example, as the debt crisis swept through Europe in 2010 and 2011, many investors cut their allocation to the European debt markets, due to the increased likelihood of default on sovereign debt. As the crisis deepened, this proved to be a wise move by traders that didn't hesitate to get out.

In addition, signs that a certain industry will become less profitable in the future can be the trigger to initiate credit-defense trades within your portfolio. For instance, increased competition in an industry(perhaps due to reduced barriers to entry)can cause increased competition and downward pressure on profit margins for all companies within that industry. This can lead to some of the weaker companies being forced out of the market, or, worse case, declaring bankruptcy.

4. Sector-Rotation Trades

In contrast to the credit-defense trade that primarily seeks to protect the portfolio, the sector-rotation trades seek to re-allocate capital to sectors that are expected to outperform relative to an industry or another sector. At the sector level, one commonly used strategy is to rotate bonds between cyclical and non-cyclical sectors, depending on where you believe the economy is headed.

For instance, in the U.S. recession that began in 2007/08, many investors and portfolio managers rotated their bond portfolios out of cyclical sectors (like retail), and into non-cyclical sectors (consumer staples). Those who were slow or reluctant to trade out of cyclical sectors found their portfolio underperforming relative to others.

5. Yield Curve Adjustments

The duration of a bond portfolio is a measure of the bond's price sensitivity to changes in interest rates. High-duration bonds have a higher sensitivity to changes in interest rates, and vice versa, with low-duration bonds. For example, a bond portfolio with a duration of five years can be expected to change in value by 5%for a 1%change in interest rates.

The yield curve adjustment trade involves changing the duration of your bond portfolio to gain increased or decreased sensitivity to interest rates, depending on your view of the direction of interest rates. Since the price of bonds is inversely correlated to interest rates—meaning a decrease in interest rates increases bond prices, and an increase in interest rates results in a decrease in bond prices—increasing the bond portfolio's duration in anticipation of a decrease in interest rates can be one option for the trader.

For example, in the 1980s, when interest rates were in the double digits, if a trader could have predicted the steady decrease in interest rates in the following years, they could have increased the duration of their bond portfolio in anticipation of the drop.

The Bottom Line

These aresome of the most common reasons investors and managers trade bonds. Sometimes, the best trade can be no trade at all. Thus, to be successful trading bonds, investors should understand both the reasons why and why not to trade bonds.