When other entities such as companies or governments need to raise funds for new projects, fund operations, or refinance existing debt, they may issue bonds directly to investors. Many corporate and government bonds are publicly traded on exchanges.
At the same time, the capital market is constantly at a low ebb. Interest rates can rise or fall. Commodity prices may spike unexpectedly, or they may crash unexpectedly. Recession and prosperity come and go. The company can declare bankruptcy or come back from the brink of death. In anticipation and response to these types of events, investors often adjust their investment portfolios to protect or profit from changes in the market environment.
In order to understand where investors can find opportunities in the bond market, we will examine some of the most common reasons why investors trade bonds.
- There are many reasons for investors to trade bonds, two of the most critical are profit and protection.
- Investors can increase yields by trading bonds (trading to bonds with higher yields) or benefit from credit upgrades (increasing bond prices after upgrades).
- Bonds can be traded for protection, which includes credit defense, which involves the withdrawal of funds from bonds in industries that may be troubled in the future.
1. Production increase
The first (and most common) reason investors trade bonds is to increase the yield of their investment portfolio. Yield refers to the total return you can expect to get if you hold a bond to maturity. It is a return that many investors try to maximize.
For example, if you have investment-grade BBB bonds with a yield of 5.5% in Company X, and you see that the yield of similarly-rated bonds in Company Y is 5.75%, what would you do? If you think that credit risk is negligible, then selling X bonds and buying Y bonds will give you a 0.25% interest rate differential gain or an increase in the rate of return. This type of transaction is probably the most common, because investors and investment managers want to maximize returns.
2. Credit upgrade trade
There are usually three major corporate and national (or sovereign) debt credit rating providers-Fitch, Moody’s, and Standard & Poor’s. Credit ratings reflect the views of these credit rating agencies on the possibility of debt repayment, and fluctuations in these credit ratings may bring trading opportunities.
If investors expect that a certain debt issue will be escalated in the near future, they can use a credit upgrade transaction. When bond issuers are upgraded, bond prices generally rise and yields fall. The credit rating agency’s upward adjustment reflects its belief that the company’s risks have been reduced, and its financial situation and business prospects have improved.
In credit upgrade transactions, investors try to capture the expected price increase by buying bonds before the credit upgrade. However, to successfully carry out this transaction, certain credit analysis skills are required. In addition, credit upgrade types of transactions usually occur near the dividing point between investment grade and lower than investment grade ratings. The jump from junk bond level to investment level can bring considerable profits to traders. One of the main reasons for this is that many institutional investors are restricted from buying bonds that are below investment grade.
3. Credit defense transactions
The next popular transaction is the credit defense transaction. In times of increasing economic and market instability, certain sectors are more prone to default than others. Therefore, traders can take a more defensive stance and withdraw funds from industries that are expected to perform poorly or most uncertain.
For example, as the European debt crisis swept across Europe in 2010 and 2011, many investors reduced their allocation to the European debt market due to the increased possibility of sovereign debt default. As the crisis deepened, it proved to be a wise move for traders who did not hesitate to exit.
In addition, signs of a decline in the future profitability of an industry may trigger the initiation of credit defense transactions in your portfolio. For example, increased competition in an industry (perhaps due to lower barriers to entry) may lead to increased competition and lower profit margin pressure for all companies in the industry. This may result in some weaker companies being forced to withdraw from the market, or worse, declaring bankruptcy.
4. Industry rotation
In contrast to credit defense transactions that primarily seek to protect investment portfolios, sectoral rotation transactions seek to reallocate capital to industries that are expected to perform better relative to one industry or another. At the industry level, a commonly used strategy is to rotate bonds between cyclical and non-cyclical industries, depending on the direction you think the economy is developing.
For example, during the US recession that began in 2007/08, many investors and portfolio managers shifted their bond portfolios from cyclical industries (such as retail) to non-cyclical industries (consumer staples). Those who are slow or unwilling to exit cyclical industries find that their portfolios are performing poorly relative to others.
5. Yield curve adjustment
The duration of a bond portfolio is a measure of the sensitivity of bond prices to changes in interest rates. High-duration bonds are more sensitive to changes in interest rates, conversely, low-duration bonds. For example, for a 1% interest rate change, the value of a bond portfolio with a maturity of 5 years is expected to change by 5%.
Yield curve adjustment transactions involve changing the duration of your bond portfolio to increase or decrease sensitivity to interest rates, depending on your view of the direction of interest rates. Since the price of bonds is inversely proportional to interest rates-which means that lower interest rates will increase bond prices, and rising interest rates will cause bond prices to fall-increasing the duration of the bond portfolio in the context of expected lower interest rates can become a trader choose.
For example, in the 1980s, when interest rates were in the double digits, if traders could predict that interest rates would fall steadily in the next few years, they could have increased the duration of their bond portfolio in anticipation of the decline.
These are some of the most common reasons investors and managers trade bonds. Sometimes, the best deal may not be a deal at all. Therefore, to successfully trade bonds, investors should understand the reasons and reasons for trading bonds.