Beginner's Guide to Trading Fixed Income: Part 3 - Mechanics of trading a fixed-income security
Part 3 - Mechanics of trading a fixed-income security
Now that we've examined the basic structure of the fixed-income market and some of the challenges facing individual investors, as well as what the process of evaluating a fixed-income security should look like, we will move on to evaluate some of the tools and resources fixed-income traders might use, before finishing with a step-by-step look at a hypothetical fixed-income trade.
Tools and resources for trading fixed income
There is a variety of tools that can help you trade fixed income, but the ones you choose will depend on how sophisticated your trading and analysis is, your budget and your personal preference. Perhaps the most robust tool available for trading fixed income is the Bloomberg terminal. The system provides users with market monitoring capabilities, bond analysis tools, financial data, pricing information and even the ability to trade bonds online. In particular, the bond analysis and evaluation tools that Bloomberg offers are superior to those of almost any other system, greatly aiding users in determining a fair value for a bond.
While there's no doubt that Bloomberg is a great tool, the downside is that it is extremely expensive. Small investors, or those that rarely trade fixed income, are unlikely to derive enough benefit from Bloomberg in order to justify its cost. Investors with very large portfolios or those that are active in trading fixed income may wish to evaluate the system, however, in order to determine whether or not its usefulness justifies its cost.
As a less expensive alternative to Bloomberg, many brokerage firm websites offer bond screening and analysis tools to their customers. These sites also usually provide tools for monitoring bond market activity, as well as fixed-income research. At very large firms such as Bank of America or Morgan Stanley, this research is likely to be generated in-house, while many smaller or online brokerage firms offer research through third-party agreements.
In addition to brokerage firms, you can also find a great deal of additional fixed income research online. One good place to check is on the websites of some of the larger money management firms. Firms such as PIMCO, Blackrock and Western Asset Management generate large amounts of research for their clients. Depending on the firm, this research may only be available to registered clients, but oftentimes the research is available to the general public, so it pays to search around the Internet and determine what research is available and to your liking. And as with the stock market, paying close attention to the financial news will help you to stay abreast of movements in the fixed-income market. Everyone has their own favorite news source, but Bloomberg News, the Financial Times and the Wall Street Journal are good places to start your search for news on the bond market.
Finally, there are tools available for the actual trading of fixed-income securities. Many of these are geared towards institutional investors, and although systems such as Tradeweb (for government bonds) and MarketAxess (for corporate bonds) are ubiquitous in the institutional investing community, they are probably overkill for the average retail investor. More brokerage firms are beginning to offer online execution for bonds, however, and some of them (such as Schwab) have begun to aggregate bond offerings from a variety of different dealers. This gives investors a better idea of what the market actually looks like and allows them to quickly and easily select the best price.
SEE: Advanced Bond Concepts
Nuances for different types of fixed income
For the most part, you will follow the same approach regardless of the type of fixed-income security you are trading. However, there are some important differences among the asset classes. For instance, when it comes to trading Treasury bonds, pricing should be very competitive among dealers, and it should be very easy for you to get a fair market price. Some investors also like to buy Treasury bonds at auction; this is relatively easy to do either through a dealer or on your own directly from the government (for more information visit the website www.treasurydirect.gov)
On the other hand, the municipal bond market is much less liquid than the Treasury market. Therefore, it is very important to check with multiple dealers prior to buying or selling a security. Different dealers will likely have different inventory that they can offer and, depending on a variety of factors, pricing among dealers can vary widely. Even with new issues in the municipal bond market, you may want to talk to different dealers because those involved in underwriting the issue are likely to have a better chance of getting you bonds.
The corporate bond market is a bit of a hybrid of the municipal bond and Treasury bond markets. For the largest and most liquid issues, offerings and prices among dealers should be relatively similar, while for smaller and less liquid issues pricing can vary widely and you may have to check with a number of dealers in order to find the bonds you're looking for or to attain the best price.
Regardless of the bond market sector you are trading, in general, the larger the bond issue, the more liquid it will be and the easier it will be to trade. Pricing on these larger issues should be relatively similar across dealers. On the other hand, the smaller the bond issue, the less liquid it will likely be and the more difficult to trade. Pricing on smaller issues can vary widely among dealers so it is important to look around.
Important: It almost always pays to check pricing with more than one dealer prior to executing a fixed-income sale or purchase. In fact, doing this is so important that many large institutions have written into their investment policies that whenever possible at least three bids or offers for a security must be procured. Investors who execute a trade after checking a price with only a single dealer do so at their own peril.
Step by step: trading a fixed-income security
The following is a step-by-step example of how a hypothetical fixed-income trade might proceed.
Step 1: Determine what you are trying to accomplish in your portfolio with this particular bond (are you seeking safety, tax-advantage, income, etc ...).
Step 2: Determine the characteristics you are seeking (type of bond, credit quality, maturity, etc …).
Step 3: Focus upon a particular issue or range of issues.
Step 4: Determine what issues your broker has available and match against your focus issues.
Step 5: Ascertain a fair value for the bond you are purchasing and compare that to the offering price.
Step 6: If the price is right, execute the trade.
Step 7: Continue to monitor the position because, just as with a stock, a bond's quality can deteriorate and/or its price can gyrate beyond reasonable value.
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