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Trading Bonds

How are bonds selected and traded? In this article, Prof Aaron Gilbert discusses this topic.
  • Just like stocks we have two options for buying bonds.
  • We can purchase a bond directly from the issuing company when they issue new bonds.
  • Many new bond issues are never offered to individual investors. New bonds go directly to institutional investors, such as fund managers and insurance companies.
  • Just like with a stock, you apply to the company issuing the bond, or their representing investment bank.
  • In some cases, the exact coupon rate may not yet be known with the company setting the rate based on demand for the bond.
  • This is obviously less attractive to investors as it raises uncertainty about how much the bond will yield.
  • Bonds may also be purchased from secondary debt exchanges.
  • Watch the above video that explains the process based on a bond listed on the London debt exchange.

Selecting a Bond

  • Picking bonds is considerably simpler than selecting stocks to include in a portfolio. So, what should you pay attention to:
  • Maturity. If we hold a bond to maturity then we can be reasonably sure of the yield we will receive on our bond.
    • Therefore, an ideal strategy is to try and select bonds that match your investment horizon. Buying a 5-year bond when you have a 10-year investment horizon leaves you open to the risk that interest rates will have changed by the time your bond matures and you may not be able to get a bond that will yield as much as you need.
    • Equally, if we bought a 10-year bond for a 5-year investment horizon we will need to sell the bond early, leaving us open to changes in prices that might cause capital losses. Matching our investment horizon, as much as is possible, reduces much of this risk.
  • Credit Rating. A highly rated AAA rated bond is extremely safe which also means it won’t have a great yield. In contrast a B- rated bond will have a great yield but represents a lot of risk.
    • Credit rating is an important indicator of the risk you are taking which should be matched to the risk you are willing to take. Investing in junk bonds (BB+ or lower rated bonds) can significantly increase your returns but you need to be careful, especially if you are extremely risk adverse.
  • Fixed vs Floating Coupons – fixed vs floating coupon rates are important depending on the state of the world and our expectations about interest rates in the future (although forecasting the future is often a fool’s errand).
    • Take the present for instance, thanks to COVID interest rates are extremely low, and in many countries so low that it is hard to see them getting lower! Over time therefore we would expect the official interest rates to increase.
    • Buying a fixed rate bond today, especially with a long maturity, could mean years of lower coupon payments.
    • Conversely, a floating rate bond will lift as interest rates increase. If the opposite were true, and interest rates were extremely high, then we might expect that they will fall.
    • In that case, floating rate bonds will see our coupons decrease if interest rates fall, while a fixed rate bond will have us laughing all the way to the bank. Something to consider though, companies have very smart people advising them!
    • When interest rates are low, we tend to see more fixed rate bonds, while when they are high the opposite is true so we might have limited choices for our preferred bond type.
  • Bond Features – we also need to consider other features like call provisions which could impact our investment.
    • Having a bond called early will often be to our detriment as companies will typically do this when their bond has a higher coupon rate then they would have to pay on a new bond.
    • A bond secured against specific assets gives us a better chance of repayment in bankruptcy, or at least will help to maximise what we get back.
    • The seniority of our debt determines where in the queue for repayment we stand, towards the front is better for repayment but safer also means lower yield.
  • Overall, what we are trying to do is select bonds which collectively will give us a yield that matches what we need to achieve our goals.
  • If we need a portfolio that has slightly higher returns than we might look at longer maturity bonds, which have higher yields, or lower rated bonds to increase our yields.
  • Additionally holding a range of bonds will help to reduce the risk of default in any one company.
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How to Invest: Modern-Day Financial Decisions

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