Factors affecting the capital markets are constantly in a state of ebb and flow. Interest rates can go up, and they can go down. Commodity prices can unexpectedly surge and can unexpectedly crash. Recessions and booms come and go. Companies can declare bankruptcy or come back from the brink of death. In anticipation and reaction to these types of events, investors often adjust their portfolios to protect or profit from the change in market circumstances. To see where investors can find opportunities in the bond markets, we will look at some of the most common reasons why investors trade bonds. (Several factors affect the taxable interest that must be reported. Learn more, in Taxation Rules For Bond Investors.)
TUTORIAL: Bond Basics
The first (and most common) reason for investors to trade bonds is to increase the yield on their portfolios. Yield refers to the total return you can expect you receive if you hold a bond to maturity, and is one return many investors attempt to maximize. For example, if you own investment grade BBB bonds in Company X yielding 5.50% and you see that the yield on similar rated bonds in Company Y traded at 5.75%, what would you do? If you believed the credit risk to be negligible, selling the X bonds and purchasing the Y ones would net you a spread gain, or yield pickup of 0.25%. This trade is perhaps the most common because of investors and investment managers' desires to always maximize yield.
There are generally three main providers of credit ratings for companies and country debt – Fitch, Moody's and Standard and Poor's. The credit rating reflects the opinion of these credit rating agencies, on the likelihood that a debt obligation will be repaid, and it is the changes in these credit ratings that can present a trading opportunity.
The credit-upgrade trade can be used if an investor anticipates that a certain debt issue will be upgraded in the near-future. When an upgrade occurs on a bond issuer, generally the price of the bond increases and the yield decreases. An upgrade by the credit rating agency reflects its opinion that the company has become less risky and its financial position and business prospects have improved.
In the credit-upgrade trade, the investor is attempting to capture this anticipated price increase by purchasing the bond before the credit upgrade. However, doing this trade successfully requires some skill at performing credit analysis. In addition, credit-upgrade type trades typically occur around the cut-off between investment grade ratings and below investment grade ratings. The jump up from junk bond status to investment grade can result in significant profits for the trader. One of the main reasons is because many institutional investors are restricted from buying debt that is rated below investment grade.
The next popular trade is the credit-defense trade. In times of increasing instability in the economy and the markets, certain sectors become more vulnerable to defaulting on their debt obligations than others. As a result, the trader can adopt a more defensive position and pull money out of sectors expected to do poorly, or those with the most uncertainty. For example, as the debt crisis swept through Europe in 2010 and 2011, many investors cut their allocation to the European debt markets, due to the increased likelihood of default on sovereign debt. As the crisis deepened, this proved to be a wise move by traders that didn't hesitate to get out.
In addition, signs that a certain industry will become less profitable in the future can be the trigger to initiate credit-defense trades within your portfolio. For instance, increased competition in an industry, perhaps due to reduced barriers to entry, can cause increased competition and downward pressure on profit margins for all companies within that industry. This can lead to some of the weaker companies being forced out of the market, or, worse case, declaring bankruptcy. (Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy. Check out The Bear On Bonds.)
In contrast to the credit-defense trade that primarily seeks to protect the portfolio, the sector-rotation trades seek to re-allocate capital to sectors that are expected to outperform relative to an industry or other sector. At the sector level, one commonly used strategy is to rotate bonds between cyclical and non-cyclical sectors, depending on where you believe the economy is headed. For instance, in the U.S. recession that began in 2007/08, many investors and portfolio managers rotated their bond portfolios out of cyclical sectors (like retail), and into non-cyclical sectors (consumer staples). Those who were slow or reluctant to trade out of cyclical sectors found their portfolio underperforming relative to others.
Yield Curve Adjustments
The duration of a bond portfolio is a measure of the bond's price sensitivity to changes in interest rates. High duration bonds have higher sensitivity to changes in interest rates, and vice versa, with low duration bonds. For example, a bond portfolio with duration of five can be expected to change in value by 5% for a 1% change in interest rates.
The yield curve adjustment trade involves changing the duration of your bond portfolio to gain increased or decreased sensitivity to interest rates, depending on your view of the direction of interest rates. Because the price of bonds is inversely correlated to interest rates – meaning a decrease in interest rates result in an increase in bond prices, and an increase in interest rates result in a decrease in bond prices – increasing the bond portfolio's duration in anticipation of a decrease in interest rates can be one option for the trader.
For example, in the 1980s, when interest rates were in the double digits, if a trader could have predicted the steady decrease in interest rates in the following years, he could have increased the duration of their bond portfolio in anticipation of the drop.
The Bottom Line
This article introduced only a few of the common reasons investors and managers trade bonds. Sometimes, the best trade can be no trade at all. Thus, to be successful trading bonds, investors should understand both the reasons why and why not to trade bonds. (Learn the basic rules that govern how bond prices are determined. See How Bond Market Pricing Works.)