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Lesson 7: Bonds

Lesson 7: Bonds

You hear a lot about bonds when interest rates are rising. Investing in bonds can help grow your wealth and balance your portfolio.

Learning how to buy bonds is an essential part of your education as an investor. A well-diversified investment portfolio should strike a balance between equities and fixed income, letting you ride out volatility while capturing growth along the way.

Which bond asset you decide to use depends on your investment goals, timelines, and available capital. If you want to invest in bonds right away, here is a quick guide:

  1. Trading CFDs on Bonds - If you’d prefer to take short-term positions to either hedge or speculate on interest rate movements.
  2. Buying Bond ETFs – if you aim to earn an income, diversify your investment portfolio, and have a long-term view.
  3. Opening an accountcomplete the registration form with CAPEX.com to access bond markets within minutes.

For more info about how to trade or invest in the bond market, discover everything you need to know in this guide.

What are bonds and how do they work?

Definition: A bond is a financial instrument that works by allowing individuals to loan cash to institutions such as governments or companies. The institution will pay a defined interest rate on the investment for the duration of the bond and then give the original sum back at the end of the loan's term.

As noted in the above bond definition, is a type of loan in which the bond issuer owes the bondholder a repayment of the initial loan amount, plus a series of interest payments called coupons. These are frequently paid on an annual or bi-annual basis. The initial loan amount – or principal – is then repaid last, when the bond reaches its maturity.

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.

buy bonds - free stock capex.com

Types of bonds

A wide variety of bonds are available. In practice, bonds are frequently defined by the identity of their issuer – governments, corporations, municipalities, and governmental agencies. When needing to raise capital for investment or to support current expenditure, issuers may find more favorable interest rates and terms in the bond market than those offered by other credit channels like banks.

What are Government bonds?

In the US, they’re called Treasury Bonds. While all investment incurs risk, sovereign bonds from established and stable economies are regarded as being low risk. In the UK, government-issued bonds are known as gilts.

US Treasury bills (or T-bills) are bonds with a maturity of one year or less; Treasury notes (T-notes) have a maturity of between two and ten years, and Treasury bonds (T-bonds) have terms of 30 years.

Whereas most government-issued bonds in the US, UK, and Germany have a fixed interest rate, both offer types that vary the coupon payment based on inflation.

The most liquid government bonds are:

What are Corporate bonds?

Corporate bonds are issued by corporations to secure funding for investment. Although high-quality bonds from well-established companies are seen as a conservative investment, they still incur more risk than government bonds and pay higher interest.

When you buy a corporate bond, you become a creditor and enjoy more protection from a loss than shareholders – ie if the company is liquidated, bondholders are compensated before shareholders. Corporate bonds are evaluated by rating agencies like Standard & Poor’s, Moody’s, and Fitch Ratings.

The largest corporate bonds ETFs are:

Bond prices and interest rates

Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa.

Interest rates can have a major impact on both the supply and demand for bonds. If interest rates are lower than the coupon rate on a bond, demand for that bond will rise as it represents a better investment. On the other hand, if interest rates rise above the coupon rate of the bond, demand will drop.

Similarly, bond issuers may constrain their supply if interest rates are too high to make borrowing an affordable source of capital. The rule of thumb is that interest rates and bond prices are inversely correlated – as one rises, so the other falls.

When deciding how you would like to trade or invest in bonds, it’s crucial to understand how interest rates will affect your overall strategy.

US bond prices and the Fed

As the Federal Reserve is the monetary authority of the world’s largest economy, the policy decisions it makes have global repercussions. When the Fed drops interest rates, for example, demand in the very large market for Treasury Bonds increases as those issued with coupon rates above the general interest rate become attractive to investors.

Institutional investors with significant holdings of US Treasuries, such as pension funds, mutual funds, ETFs, and investment banks and trusts, will see an appreciation of their assets with the rise in US Treasuries and other US bond prices.

Why Invest in Bonds?

Bonds tend to offer a reliable cash flow, which makes them a good investment option for income investors. A well-diversified bond portfolio can provide predictable returns, with less volatility than equities and a better yield than money market funds.

Even when interest rates are low, bond investing options like high-yield debt or emerging market bonds can meet an investor’s need for income, although with substantially more risk.

People invest in bonds for four primary reasons:

Portfolio diversification

Portfolio diversification is a way to spread investment risk across many uncorrelated assets. Whereas including numerous different stocks, from several independent industries, in your portfolio minimizes the risk associated with each, you’ll still be exposed to market risk.

To diversify your portfolio with bonds, you don’t have to hold actual bonds. You can achieve similar results by purchasing shares in a bond ETF.

Income investing

Income investing is a strategy designed to earn regular, predictable revenues from assets. Building an income portfolio involves buying instruments like coupon-paying bonds and dividend-paying shares from companies, investment trusts, ETFs, and mutual funds.

Instead of paying coupons, bond ETF shares pay dividends from coupon and principal repayments made by their bond holdings.

Hedging

When implemented correctly, hedging can be seen to mitigate your losses should the market turn against an investment you’ve made. It’s achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other.

Any strategy adopted when hedging is primarily defensive in nature – meaning that it’s designed to minimize loss rather than to maximize profit.

Speculation on interest rate changes

Owing to the inverse relationship between bond prices and interest rates – ie as interest rates rise, so bond prices fall, and vice-versa – bonds enable you to speculate on interest rate movements.

You can do this by taking a position in the government bonds futures market using CFDs, which are explained below.

How to Invest in Bonds

It’s possible to buy bonds directly from the issuer. While that makes sense in some situations, ordinary investors more frequently buy, sell and trade bonds using one of the following methods:

  • Trading individual bonds through a brokerage account: You can trade bonds through most brokers just like you would trade stocks or indexes.
  • Buying bond ETFs: You don’t need to make decisions about specific bonds to purchase when you buy an exchange-traded fund (ETF). Instead, the ETF company chooses them for you and often categorizes them according to their type or duration.

Trading Bond CFDs

Bond trading is one-way investors can gain exposure to the bond market without having to buy bonds directly. Many view it as an essential part of a diversified trading portfolio, alongside stocks. When trading you speculate on the price movement of the underlying asset.

Bond Trading Capex.com
Source: CAPEX WebTrader

Trading incurs significant risk. This risk is only amplified when trading with leveraged derivatives like CFDs as you stand to lose more than the margin amount you deposited to open a position. Additionally, when short selling, your losses could be unlimited because bond prices can keep rising – theoretically without limit. This means that when taking a short position, you stand to incur losses. You can attach a stop-loss order to your positions to protect yourself by capping your loss during normal market conditions.

Before trading with leveraged derivatives like CFDs, remember that they’re complex instruments and that both profits and losses can accrue rapidly.

Here are some popular techniques for trading bonds.

Going 'long' on lower interest rates

When interest rates drop, bonds become more desirable, and their prices rise. If you believe this will be the case, you’d adopt a ‘long’ position on your chosen government bond futures market. When going long, you elect to ‘buy’ a derivative to open your trade.

To close your trade, you’d then ‘sell’ the derivative. Should the price of the government bonds futures contract increase, you’ll earn a profit. Conversely, should the price decrease, you would cut a loss.

Going 'short' on higher interest rates

When interest rates rise, bonds become less desirable, and their prices drop. If you think this is set to happen, you’d adopt a ‘short’ position on one of our government bonds futures.

When going short, you elect to ‘sell’ a derivative to open your trade. To close your trade, you’d ‘buy’ the derivative back. You’d earn a profit if you sold for a higher amount than you bought at and cut a loss if the reverse were true.

Hedging against inflation

Taking a short position on a government bond can be a way to hedge against possible downturns in the real income earned from shares and bonds you already own.

Inflation is an increase in the aggregate price level as measured by changes to a price index, like the CPI. When inflation is high, the dividends paid by shares and the fixed coupons paid by bonds both lose value in real terms – ie they have lower purchasing power.

This, in turn, negatively affects each asset’s market demand and price. By shorting the bond market and potentially profiting from the decrease in bond prices, you could lessen some of your real income losses.

Hedging against interest rate risk

Interest rate risk is the possibility of rising interest rates causing the value of an investment to fall. Fixed-income assets like bonds are exposed to this type of risk. If you hold bonds or shares in a bond ETF and expect to cut a loss owing to a hike in interest rates, you could hedge by going short on the government bonds futures market.

For example, if you think the Federal Reserve (FED) is going to increase interest rates, you could open a position on the US Treasury bonds by electing to ‘sell’ a derivative like CFDs. If your prediction is correct and bond prices fall, your profit on the trade would mitigate the loss to your other investments.

How to Trade Bonds CFDs with CAPEX.com

To trade government bond futures markets with CAPEX.com, follow the steps below. You will need a Trading account.

  • Create an account or log in
  • Pick a government bond futures contract from within our trading platform
  • Select ‘buy’ to go long, or ‘sell’ to go short. Set your position size and take steps to manage your risk
  • Open and monitor your position
US Treasuries trading CAPEX.com
Source: CAPEX WebTrader

Buying Bond ETFs

When investing, you will buy shares in bond ETFs through a traditional stock account. When investing you take direct ownership of shares in a bond ETF.

Here are some tips to consider before buying bonds.

Look at the credit rating

Bond coupon rates should provide a return in proportion to the risk you take when buying the bond. Rating agencies like Standard & Poor’s, Moody’s, and Fitch Ratings assess the credit risk associated with both bonds and bond issuers.

The ratings they give bonds can be used to determine whether the yields offered by each are competitive. Bonds with low ratings should offer higher coupon rates. Bond ETFs also look to credit ratings to determine their risk and expected returns.

For example, whereas high yield (or ‘junk bonds’) pay higher coupon rates, they also incur considerable default risk (ie that the issuer will not be able to meet debt obligations).

Consider a bond or bond ETFs interest rate risk

Interest rate risk is the potential that rising interest rates will cause the value of bonds and bond ETFs to fall. That is, when rates are high, investors could get a better return elsewhere, and demand for bonds declines. A measure of the percentage change in price due to a movement in interest rates is called a bond’s ‘modified duration’.

Bonds with longer terms to maturity are generally more sensitive to interest rate fluctuations, and therefore have a higher level of interest rate risk.

Because market interest rates include the inflation rate as part of their total value, inflation-protected bonds are less exposed to interest rate risk as they adjust coupon rates and principal amounts to meet inflation. In the UK, government Index-linked gilts vary rates in line with inflation, while the US equivalents are Treasury Inflation-Protected Securities (TIPS).

Know the maturity date of the bond or bonds held by an ETF

The maturities of bonds are extremely important. Bonds with longer maturities are typically issued with higher coupon rates – and higher yields to maturity – than shorter-term bonds. This is because they’re more susceptible to the various types of risk incurred by bonds, including interest rate risk, inflation risk, credit risk, and liquidity risk.

Bond ETFs may specialize in bonds with set maturations, like the ten-year US Treasury bills (T-bills). The value – and share prices – of a long-term ETF may be more volatile than bond ETFs focused on shorter-term securities. This potential volatility should form part of your investment strategy.

Factor in the coupon or dividend payment

A primary reason for looking at bonds or bond ETFs as investments are the goal to earn an income. This makes the coupon rate on the bond, or the dividends in the case of an ETF, a central consideration in your planning.

The determination of coupon rates is complex and depends to a large extent on a bond’s credit rating, the prevailing interest rates for comparative levels of risk, and the bond’s term to maturity. Whereas bonds with lower credit ratings and longer terms have higher yields, they are more exposed to risk.

How to Buy Bond ETFs with CAPEX.com

To invest in bond ETFs yourself with CAPEX.com, follow the steps below. You will need an Invest account.

  • Create an account or log in
  • Familiarise yourself with our offering of bond ETFs
  • Select your asset
  • Determine the size of your investment and order type
  • Open and monitor your position
buy bond ETFs
Source: CAPEX WebTrader

Are bonds a good investment?

Bonds have advantages and disadvantages, just like any other investment.

Bonds offer benefits that make them a valuable counterparts to stocks in most investment portfolios. While stocks tend to offer higher returns, bonds offer other advantages:

  • Steady income: Bonds tend to offer relatively predictable returns, including regular interest payments.
  • Diversification: Bonds perform differently as investments than stocks, which helps to reduce the long-term volatility of a portfolio.
  • Lower risk: Bonds generally offer a higher degree of security than stocks, though some bonds are riskier than others.

But those advantages are balanced with the following disadvantages:

  • Lower risk, but lower return: The trade-off for less risk is less return. So, bonds are typically a “slow and steady” investment, in contrast to stock investment.
  • The price depends on interest rates: The short-term price of bonds relies on interest rates, which investors can’t control, and investors generally must take whatever rates the market offers or get nothing, creating substantial reinvestment risk.
  • Heavily exposed to inflation: Because bonds pay a fixed return (unless they’re floating-rate bonds), their value can decline precipitously if inflation moves up substantially.

These are a few of the most significant downsides to bonds, but the asset class has performed well in the U.S., Germany, or UK over the last few decades as interest rates have continued to fall.

What is the difference between bonds and stocks?

Stocks and bonds are possibly the most common terms people use when they talk about investing. Rightly so, as they’re both crucial parts of every investor’s portfolio.

Stocks give you partial ownership in a corporation, while bonds are a loan from you to a company or government. The biggest difference between bonds and stocks is how they generate profit: stocks must appreciate and be sold later in the stock market, while most bonds pay fixed interest over time.

The greatest difference between stocks and bonds is their risk levels and their return potential. Speaking very generally, stocks have historically offered higher returns than bonds but also come with increased risk. While you may earn more with stocks, you may also stand to lose more.

With safety comes lower interest rates. Long-term government bonds have historically earned about 5% in average annual returns, while the stock market has historically returned 10% annually on average. And even though there is typically less risk when you invest in bonds over stocks, bonds are not risk-free.

The bottom line is there’s no one magical investment that will never lose money or one that will always make money. That’s why a portfolio that has a mix of both is beneficial for your finances.

Should you invest in bonds?

Investing in bonds, whether trading individual bonds or buying bond ETFs, provides diversification and can be an income for your investment portfolio. With all bond-related investments, you must do your due diligence: Research issuers, compare bond ratings, and if possible, consult with your investment professional to help guide your choices.

All interest or profit earned on the investment is a reward for assuming risk. Understanding risk, and your own appetite for it, is fundamental to establishing sound trading and investment strategies that balance the potential for loss against the potential for reward.

Traditionally, bonds are looked to as investment vehicles that can diversify portfolios – and mitigate some of the risks associated with stock markets. But they are not riskless and should never be seen as a guaranteed – if low return – stream of revenue or profit.

When trying to decide how to invest in bonds, a better solution for investors who plan on holding the fund shares for an extended period might be buying a bond ETF. More active investors might prefer CFDs on bonds since there aren’t short-term redemption fees charged by many mutual funds to discourage excessive trading.

Your preference for bonds should be put into the larger context of your overall investment strategy and risk tolerances.

Free trading tools and resources

Remember, you should have some trading experience and knowledge before you decide to invest in bonds. You should consider using our educational resources, like CAPEX Academy or a demo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a more informed trader.

Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how Bond trading works – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.

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