Bond Trading should be distinguished from bond investing.
Retail investors with limited knowledge can engage in bond investing as explained in our article on bond investing.
However bond trading is conducted mostly by institutional investors although some sophisticated retail investors. While bond investing is usually characterized by low risks, bond trading involves much higher risk in pursuit of short term gains.
Bond investing involves making a return that is paid by the bond issuer (a government or corporation).
Bond trading involves making a short-term return at the expense of another trader.
There are three main strategies in bond trading.
The first is trading based on interest rate movements.
If you believe that long-term interest rates will fall then you can buy long-term bonds. If interest rates do fall as you expect, then the value of a long term bond will increase. In this strategy you hope to make a short-term capital gain by betting correctly on the direction that long-term interest rates move. This method could also be used to bet that long-term interest rates will rise. In that case an investor could sell a long-term bond short, in the hopes of buying it back later at a reduced price. (But I doubt that it is feasible for retail investors to get into selling bonds short). This interest rate based trading strategy should be accomplished strictly with government bonds since they offer the best liquidity and do not introduce company-specific risk.
The second trading strategy is based on price arbitrage
In this strategy a trader buys bonds that appear to be under-priced relative to where they should be, compared to other bonds, based on interest rates and the credit quality. This strategy is not applicable to retail investors since it would require access to the very best pricing and lightening fast trade execution.
The third strategy is based on changes in credit quality of corporate bonds.
In this strategy an investor would purchase a bond that is a bit lower in credit quality, perhaps a BBB credit rating or lower. The investor believes that the fortunes of the company will improve and that the credit rating on the bond will improve, its interest yield will decline and this will create a quick capital gain on the bond. This is a reasonable strategy for knowledgeable retail investors to follow. This strategy could be a good alternative in place of buying the common shares of a company that is in some (temporary) difficulty.
Shawn Allen, CFA, CMA, MBA, P.Eng.
April 9, 2005