You might think that trading individual bonds sounds unusual. After all, most investors generally perceive bonds as being longer-term investments that tend to have low volatility and predictable income streams.
Indeed, bond investing can be more complex for retail investors because the bond market is dominated by large, institutional investors and liquidity may not always be apparent. However, bonds are financial securities that can be bought and sold like any other.
Why might investors trade bonds?
The bond market is one of the most active markets in the world, with more than $830 billion traded daily.1 For the long-term investor, bonds can be an effective portfolio diversifier and a strong income-generating asset class. Today, technological developments have reduced many of the barriers that had previously prevented individuals from tapping the bond markets directly, rather than through a broker.
Investors who have the experience and knowledge might trade bonds for several reasons. These include:
- The search for higher income or yield. There may be an opportunity to exit a lower-yielding bond in favor of a higher yielding bond. If you are comfortable accepting potentially higher credit risk of a higher-yielding bond, for example, you might try to pick up additional yield by selling a lower-yield bond and buying a higher-yield bond. But remember: Higher yield usually means more risk. You might also decide to trade into a higher-credit-rated bond with a higher coupon and low yield, if you are willing to pay a premium.
- Credit opportunities. The credit rating of a bond is an extremely important factor when determining how the bond might perform. If you believe that the credit rating of a particular bond issuer might be upgraded in the near future and, consequently, that its bonds could appreciate in value, you might want to implement a strategy whereby you trade into bonds of that issuer. This approach requires you to do credit research on the company, sector, and the general economic, fiscal, and monetary policy factors that might affect the credit rating.
- Positioning for a changing investment outlook. If you own corporate bonds, for example, changes in economic and financial trends can have an especially strong impact on those bonds’ prices. Suppose you currently own bonds issued by a publicly traded bank, and you believe the health care sector’s growth prospects may be more enticing than those of financials. You could employ a sector rotation trade out of the financial company’s bonds and into an health insurer’s bonds, for instance. It is worth noting that this type of strategy may be more appropriately employed using other investment vehicles, such as sector exchange-traded funds (ETFs), sector mutual funds, or individual stocks, depending on your risk tolerance.
- Portfolio risk and return management. You may be able to trade bonds to better align your portfolio’s risk and return objectives, given changing dynamics in the market. Unlike owning stocks and other securities where you are continuously confronted with the decision of when and at what price to sell, bonds have a set maturity date and end price. These characteristics can help you define your risk and return objectives.
Know the risks first
Roger Young, senior vice president of fixed income at Fidelity, believes that it is easier to trade bonds now than ever before, but cautions against timing interest rate changes or implementing a sector rotation strategy using bonds—unless you are confident about what you are doing.
“The bond market is more transparent today than it was 10 years ago,” Young points out, “but that does not always mean you have access to liquidity.” Liquidity is a crucial factor to consider, as it can impact the cost of trading. He urges extreme caution, particularly in certain segments of the bond market. Municipal bonds, for instance, can be very illiquid. Despite its size, as much as 95% of the muni market does not trade daily, according to SIFMA data.2
On the other hand, there are parts of the bond market that do offer strong liquidity. “U.S. Treasuries, agency bonds, and investment-grade corporate bonds, for example, tend to offer active daily trading and narrow bid-ask spreads,” Young says. “So you can get a strong sense of how often a bond trades.”
Indeed, technology has generally made it much easier to see where a specific bond has traded, and what the best bid and best offer are. “The ability to more effectively trade bonds is available, but I believe it is not as easy as trading stocks,” notes Young. “Depending on your experience and knowledge level, trading bonds may be better left in the hands of a professional or in a managed portfolio.”
Examining liquidity and costs
If you are going to consider trading bonds, you should be aware that there may be bonds that are more costly—in terms of wide bid-ask spreads—due to low liquidity. While there are stocks that also have low liquidity and wide bid-ask spreads, bonds trade over the counter and, therefore, there is no formalized exchange where trading takes place. Thus, trading activity can vary widely across bonds, and this may even be the case for the bonds of well-known corporations. It may be difficult to sell a holding in inactive markets and, as a result, you may have to accept an outlier (potentially costly) bid to liquidate your position.
Of course, liquidity is just one of many factors that should be considered when analyzing a bond. While trading commissions may not be that large for certain bond transactions, for investors looking to buy or sell small lots of bonds in the secondary market, the profitability of that trade could be significantly affected by large bid-ask spreads.
Bond investors empowered
A note about bond trading activity.
Even though the bond universe is quite large—far bigger than the stock market, in fact—the secondary market for bonds (where most retail investors would trade bonds) is not nearly as large as the overall bond market (see sidebar). Consequently, the bond market is not as intimidating as you think it might be at first glance.
However, it can be somewhat difficult for retail investors to identify when a particular bond security lacks liquidity—a crucial characteristic when you are evaluating different bonds. The good news is that technological innovations that Fidelity has embraced offer you the tools to help assess these factors.
Transparency is more available today when you look at an individual bond investment strategy. In the case of a corporate bond, for instance, depth of book refers to the display of numerous bids and offers in a given security. In addition to the best bid and offer price, depth of book enables investors to see beyond the best bid or offer price—which may be of limited quantity.
Fidelity.com allows you to view depth of book (navigate to the Research tab, select Fixed Income & Bonds, then search by yields, and select a bond security from the table), as well as other characteristics of specific bonds, including bid-ask spread. Obviously, actively traded securities with narrower bid-ask spreads may be preferable.
This availability of pricing transparency, as well as other factors, including inventory aggregation, has played a large role in improving execution costs when trading in bonds.
Managing your bond portfolio
While there are some unique aspects of bond trading to be aware of, being able to actively buy and sell bonds may enhance your ability to manage your portfolio. Fidelity customers can buy or sell secondary-market bonds, buy new-issue bond offerings, and trade fixed income on margin (with a signed margin agreement).
Still, for many investors, actively trading bonds may simply be costly and risky, and it may make more sense to invest in a bond mutual fund or ETF. If you are interested in trading bonds, explore the tools that are at your disposal or consider contacting your Fidelity representative to learn more about actively managing your bond positions.