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:
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.
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.
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.
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