Last Updated on 13 January, 2021 by Samuelsson
Bond trading is the buying and selling of bonds. An investor can either trade old or new bonds. New bonds are issued in primary markets all over the world and you can buy these bonds and receive a certain predetermined interest.
Alternatively, which is the most common, bond trading also includes buying and selling of bonds in secondary markets. These markets allow investors to make money on the bonds before their maturity. Buying and selling bonds in the secondary market entails selling the bonds for a given price, which is determined on the basis of the economic outlook and creditworthiness of the issuer.
Where Can You Trade Bonds
Bonds can be traded in exchanges, directly from the U.S. Treasury Department, as well as in over the counter markets.
If you want to trade bonds you do so best by creating an account with an online brokerage. There you can decide to either trade the bonds themselves, or ETFs that track bonds.
Alternatively, investors can also buy and sell their bonds at over the counter markets. Over the Counter markets are different than exchanges in that they are less transparent than exchanges. However, at the same time, they are also less exposed to limiting regulations.
It is highly recommended to trade on a regulated exchange through a broker!
How Does Bond Trading Work?
Essentially when a person buys a bond, they are buying the debt of the bond issuer. This bond issuer can be the government or a corporation. Every bond has a maturity date, upon which the bond issuer is liable to pay the principal and sometimes also the interest to the bondholder. An investor in bonds can either hold a bond till the end to receive the payment or sell it before the maturity date.
If an investor sells a bond before the maturity date, they hope to earn capital gains (the difference between buying and selling price) on these bonds. The prices for bonds with the same interest rate are different because not all bonds are created equal. Some bonds issuers, such as governments, are more trustworthy which means that the risk of losing all money is very low. Therefore, the prices of more trustworthy bonds will be higher than more risky bonds with the same interest rates.
When an investor buys a bond, they are betting on two things:
- First, they are betting that the creditworthiness of the issuer is stronger than the market realizes. Later, when the market catches up, the price of the bond is expected to rise.
- Second, they are betting that the economy until the time of the maturity will provide relatively worse returns as compared to the bond that is being purchased.
Both these bets are, of course, aimed at maximizing investors returns.
Why Do People Trade Bonds?
People trade bonds because bonds provide a number of advantages. Here are three of them:
- First, bonds suffer from less volatility as compared to stocks. This plays into the hands of investors with a low-risk trading strategy.
- Second, the interest payments on bonds often exceed the dividend payments on stocks. This could be relevant depending on the strategy of the investor.
- Third, bonds are great to have in a portfolio of stocks in order to achieve diversification.
If you enjoyed this article you might also like our other articles answering common questions traders have!