Insights Into the Bond Market and How to Trade Them

So says Michael J. McFarlin (futuresmag.com/) in edited excerpts from his original article*.

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and www.munKNEE.com (Your Key to Making Money!) has edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) the article below for the sake of clarity and brevity to ensure a fast and easy read. The report’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

McFarlin goes on to say, in part:

What is a Bond?

At the most basic level, a bond is a loan. Just as people obtain a loan from the bank, governments and companies borrow money from citizens in the form of bonds. A bond really is nothing more than a loan issued by you, the investor, to the government or company, the issuer.

For the privilege of using your money, the bond issuer pays something extra in the form of interest payments that are made at a predetermined rate and schedule. The interest rate often is referred to as the coupon, and the date on which the issuer must repay the amount borrowed, or face value, is called the maturity date.

Ratings generally can be classified as investment grade or junk. Anything that’s considered to be an investment grade, you would have a fairly high probability that you’re going to get your money back at maturity [but] the lower you go down the credit spectrum, the more risk there is of default and the possibility that you could have losses. Therefore, the lower the security grade you have, the more yield compensation you should have for taking that default risk.

[The above being the case,] if you purchased a 30-year U.S. Treasury bond (currently AA+ from S&P and AAA from Moody’s and Fitch) for $100,000 with a coupon rate of 6%, then you could expect to receive $6,000 a year for the duration of the bond and then receive the face value of $100,000 back. At least, that’s how a bond would work if you held it to maturity.

Trading Bonds

Rather than hold a bond to maturity, they also can be traded but, as a bond is traded, interest rates can change, so the overall value of the bond can change. If you bought a bond that has a 10% coupon and the rest of the market is fine with owning a 1% coupon, then someone is going to love to have that 10% coupon until maturity. Conversely, if you have a 1% bond and everyone else is expecting that the market in general will be at 10%, then you’re going to need to pay someone a lot of money to take that 1% bond instead of buying a new 10% bond.

Because coupon rates generally are fixed, to adjust for future expectations the price of the bond or note has to move up or down. If yields, the interest or dividends received on a security, go up, the price will fall to accommodate that higher yield; if yields go down, then price has to go up.

Why Trade Bonds?

Given bond characteristics, there are a number of reasons they may be attractive for active traders:

1. liquidity,
2. portfolio diversification and
3. attractive trading hours.

1. Liquidity

The U.S. Treasury futures market is gigantic and one of the most active and liquid markets in the world and is an easy place to buy into or get out of because bid-ask spreads are very narrow.

2. Portfolio Diversification

Bonds, traditionally, have provided a more conservative type of investment than equities. Treasuries tend to have a negative correlation to the equity market so, if the equity market becomes very fearful, Treasuries will tend to rally [and, as such,] is a place to hedge or diversify your risks from a portfolio perspective. [That being said,] though, this inverse relationship is not as reliable as say, gold and the dollar.

Bonds often rally on bad economic news and sell off on good news. A poor Gross Domestic Product (GDP) or employment report may lead the Federal Reserve to lower interest rates, leading to higher bond prices. Positive GDP and jobs reports or an inflationary Consumer Price Index report may indicate inflation will rise, causing the Fed to raise rates and push bond prices lower.

3. Attractive Trading Hours

The bond trading hours are attractive for two reasons:

1. the bond pits are open when most of those major reports come out and this is important because the bond market is a measure of interest rates, which are determined by economic conditions, so economic reports, especially those that measure the economy and inflation, drive the market.
2. it’s fairly easy to determine the most active trading times of the day…

Getting Started

The major Treasury contracts, five- and 10-year notes and 30-year bonds, are based on a 6% coupon rate equaling par or 100-00 as is the ultra-bond which is a 30-year bond that has at least 25 years left to maturity. Each full tick is worth $31.25; there are 32 ticks in a point or handle, equaling $1,000 per contract. Five- and 10-year notes also have 32 ticks in a point, but each tick is subdivided. The 10-year is traded in half-ticks with each half-tick worth $15.625, and the five-year is traded in quarter-ticks with each quarter-tick worth $7.8125. Because longer-term Treasuries tend to have higher yields, they tend to be more sensitive to interest rate movements. A news event that may cause a full handle move in the long bond typically results in a 16-24-tick move in the 10-year and less than a half-point move in the five-year.

Start with five- and 10-year notes, and trade multiple contracts [because] if traders can use a stop of one tick in five-years, two ticks in 10-years, then they can get entry prices you like, and lower your risk [and,] although there may be “less bang for your buck” than in the 30-year, there also is less risk. You can learn how to get in the market, manage your trade, eke out a few ticks a day. That’s unique because for guys that trade the S&P, that’s not really even an option. [In] addition, trading a second contract helps you protect your profitable trades…With a two-lot working, if the market goes your way one tick, then you can take one off, move a stop to scratch and then who knows what may happen.

Getting started in bond trading is just like learning to trade any other commodity. You have to observe all the different types of relationships to understand what it is you’re trading, and know how and why it moves the way it does.  Bonds don’t trade in a vacuum [and, as such,] you’ve got to be aware of the influences that are out there.

*http://www.futuresmag.com/Issues/2012/January-2012/Pages/How-to-understand-and.aspx

Disagree? Concur? Have your say on the subject via:

• Twitter or
• Facebook or
• the Comment section below.

We’d like to know what you have to say.

Related Articles:

1. Gold Bullion, Stocks or Bonds: Which Have More Long-term Investment Risk?

In proclaiming buy-and-hold investing to be dead, the pseudo-experts masquerading as financial advisors have abandoned the fundamental principle of investing: buying undervalued assets – and then giving those assets the time necessary to mature. Instead, these charlatans have forced their clients to become short-term gamblers. Worse still, they are now consistently steering their clients toward the worst possible asset-classes, stocks and bonds, rather than the best ones [simply because they do not] understand the fundamental conceptual difference between risk and volatility. In a market populated by panicked lemmings, we cannot avoid volatility. However, we can and must reduce risk – which begins by building an allocation of history’s true safe haven asset, precious metals. [Let me explain more about what risk and volatility are and are not.] Words: 1080

2. Your Portfolio Isn’t Adequately Diversified Without 7-15% in Precious Metals – Here’s Why

The traditional view of portfolio management is that three asset classes, stocks, bonds and cash, are sufficient to achieve diversification. This view is, quite simply, wrong because over the past 10 years gold, silver and platinum have singularly outperformed virtually all major widely accepted investment indexes. Precious metals should be considered an independent asset class and an allocation to precious metals, as the most uncorrelated asset group, is essential for proper portfolio diversification. [Let me explain.] Words: 2137

3. Don’t Invest in the Stock Market Without Reading This Article First

History has shown that investors who stick to disciplined, fundamental-focused strategies give themselves a good chance of beating the market over the long haul and James O’Shaughnessy has compiled data that stretches back to before the Great Depression…back-tested numerous strategies, and has come to some very intriguing conclusions. [Let me share some of them with you.] Words: 1325