Part 2 - Process for trading fixed-income securities
In the second section of this Beginner's Guide, we will examine more closely what a process for evaluating and trading fixed income securities might look like. This section will begin with an analysis of how an investor can screen the fixed-income universe in order to select an appropriate security or securities. We will then move on to discuss how an investor can determine what a fair price might be for the security he or she has chosen to purchase.
Screening the fixed-income universe
One of the primary challenges investors face in the fixed-income market is choosing which issue to focus on from among the plethora of available options. Screening the universe is necessary in order to narrow one's focus. The starting point for any screen of the fixed-income universe should be an investor's needs. First of all, you should consider what role within a portfolio the security you are considering will fill. Are you searching for safety, capital appreciation, tax advantages or income?
A full discussion of what securities might meet each of these primary needs is beyond the scope of this article, but briefly:
- Safety- if you're primarily interested in safety, you should focus on the highest quality securities in order to avoid credit risk and on shorter maturity securities in order to minimize interest rate risk. If safety is your goal, securities you might focus on include: U.S. Treasury and agency securities; CDs and other money market instruments; and perhaps short-term corporate debt or municipal bonds issued by the highest quality corporations and municipalities. If you are seeking safety, most of the issues you focus on should have maturities less than five years, and perhaps even under one year depending on your needs.
- Capital appreciation - if you are seeking capital gains, you are likely to focus on lower-rated securities, such as high-yield bonds or emerging market debt. You might also consider longer-maturity corporate or government bonds if you believe interest rates are likely to fall.
- Tax advantages - if you're in a high tax bracket and seeking to maximize your after-tax income, you will likely narrow your focus to tax-free municipal bonds most of the time. It still pays to consider other forms of fixed income, however, and to compare the after-tax yield on both taxable and tax-free securities.
- Income - many fixed-income investors are seeking income in their portfolio, and nearly all fixed-income securities will provide at least some income for investors (there are exceptions, such as zero-coupon bonds.) Depending on how much risk you are comfortable with, you might narrow your focus towards corporate bonds or mortgage-backed securities if income is your primary goal.
SEE: Are High-Yield Bonds Too Risky?
Another characteristic you will want to isolate is the credit rating you're looking for. Although the ratings supplied by the credit rating agencies are far from perfect, they do provide a useful starting point for credit analysis, and, in general, higher-rated securities tend to be safer than lower-rated securities. Other important characteristics that might help you narrow your search are whether you want a bond that is callable or non-callable, and in the case of corporate bonds, whether or not there is a particular industry you are seeking (diversification pays in the bond market as well as the stock market, and if you're building a portfolio of corporate bonds, you should try to diversify across industries.)
Once you determine the characteristics of the security you're seeking, you can narrow your search even further. There are two ways to do this. If you have access to a Bloomberg terminal or another sophisticated investment program, you can pull up all of the securities outstanding from a particular issuer and then narrow your focus to the one that best suits your needs. For example, if you decided that income is your primary investment goal, that taxes are not a consideration, that you want a bond with a 7- to 10-year maturity and an investment-grade rating, and you want a company in the banking industry, you might wind up focusing on several issuers.
SEE: How To Analyze Corporate Bonds With Bloomberg Terminals
In this hypothetical example, the issuers you come up with might be: Citigroup, J.P. Morgan, Bank of America, Morgan Stanley, Wells Fargo and Goldman Sachs. Let's say that you already own a Citigroup bond, a Bank of America bond, a Morgan Stanley bond and a Wells Fargo bond, and for whatever reason you're not interested in owning Goldman Sachs bonds. In that example, you have now narrowed your focus down to bonds issued by J.P. Morgan. You can then use your Bloomberg terminal to list all of J.P. Morgan's outstanding corporate bonds, focusing on those with maturities in the 7- to 10-year age. You can choose a particular issue based upon valuation, issue size or availability, and then go out and purchase it in the marketplace.
There are three potential flaws with using the prior method for selecting a particular security. The first is that not everyone has access to a Bloomberg terminal or similar system. The second is that even after performing the process described there may still be a number of bonds that meet all your criteria, and you may not have the inclination or ability to choose a particular bond. The third problem is that even after you have identified a particular bond you still need to go out and buy it, and there's no guarantee that you will eventually be able to find the bond you have focused upon at a reasonable price.
Therefore, many individual investors will find a better approach to be as follows. After having screened the universe down to a manageable size through the process listed above, you can then contact (either online or over the phone) the bond department of the brokerage firm you use in order to see what bonds they have in inventory. You can compare this inventory against your chosen criteria, thereby coming up with a shortlist of available issues that both meet your fixed income screening criteria and are available for purchase. At that point, you can choose whichever issue seems most attractive on a valuation basis and purchase it for your portfolio.
SEE: When To Trust Bond Rating Agencies
Determining a fair price for a fixed-income security
One important step in the process discussed above bears looking at more closely. While the current market price for a stock is easily attained, finding what the "fair" value for a particular bond is at a given moment can be more difficult. Therefore, we will now look more closely at some of the methods individuals can use to determine what a fair price for a fixed income security might be.
There are two main ways to determine a fair price for a bond. The first is to see where it has been trading in the market, and the second is to calculate a fair value based upon its characteristics.
The easiest way to determine what a fair price would be is to see where the bond has traded recently. Prior to the early-2000s, this was extremely difficult if not impossible to do, particularly for individual investors. However, the Financial Industry Regulatory Authority (FINRA) now requires broker-dealers to report trade prices shortly after execution for many types of bonds, through what is known as the TRACE system. These trade prices are publicly available. If you have access to Bloomberg, and are using the system to analyze bonds, you can find this TRACE data alongside the rest of the bond's characteristics. If you do not have access to Bloomberg, you can still access TRACE data through the FINRA website
Looking at the prices where a bond has traded recently will give you not only an idea of what level the bond should trade at, but also what the recent trend in price activity has been. It is important to keep in mind that if you're only interested in trading a small position of a bond, your pricing may be somewhat worse than that which you see in the TRACE data. This is because the best pricing in the bond market generally goes for executions of greater than $1 million, while smaller pieces are often penalized.
Looking at recent trade prices is a great start, but just as in the stock market, bond market trading may not accurately reflect what the "true" intrinsic value should be. Depending on market conditions, recent trades could be much higher or lower than where a bond's value actually is. Furthermore, some bonds do not trade very frequently, and if that is the case for the bond that you are seeking to buy or sell, there may not be any recent trades that have been reported to TRACE.
Under these circumstances, you might wish to calculate what you believe the fair value for a bond to be. There are a couple of ways to do this. Most bonds trade on a spread basis, because investors wish to receive additional compensation for taking risk beyond that which is inherent in Treasury securities (spread refers to the additional yield of a bond above that of a comparable Treasury security). Therefore, one way of valuing a bond would be to determine how much additional compensation you believe would be fair for the additional risk you are taking relative to a Treasury.
In general, the greater the risk you are taking, the greater the additional compensation you should get. This means that you should receive more spread for purchasing a high-yield bond tha a very high-quality investment grade bond. Similarly, you should receive more spread for buying a less liquid issue than for a very large and liquid issue and you should receive more spread for purchasing longer maturity securities than shorter maturity securities.
The final method for calculating what your target price for a trade should be is to look for levels at which comparable bonds have traded. For instance, you might decide that Oracle and IBM have reasonably similar credit profiles and should therefore trade at reasonably comparable prices. If you cannot find recent trade data on the Oracle bond that you're trying to purchase, you could instead see where a comparable IBM bond has traded and use that as a rough approximation for what the value of the Oracle bond should be.
Beginner's Guide to Trading Fixed Income: Part 3 - Mechanics of trading a fixed-income security
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