Bonds, better to Trade or to Invest?

The world of investments is truly varied and that of bonds is in some ways very special. Most savers are aware of these instruments due to their reputation as an asset that expires and provides a good "nest egg" at the end of their term, provided that the returns are actually good from the start. Is it possible to trade on these assets, that is, to speculate on price differences? Absolutely yes, even if this is an arduous terrain especially for those who are not aware of some basics that are fundamental for knowing this world. In the world of trading, traders who use bonds as a trading tool are very few and hyper-specialized as it is a market with many volumes, not very volatile and consequently with profit margins linked to low price movements in the short term.

Bonds: how do they work?

Bonds represent the financial instrument par excellence. Their operation is similar to a loan, where however it is the debtor who offers an interest rate (usually annual) for a certain number of years (maturity). Possible creditors, by buying the bond, acquire the right to receive the interest rate for a specified number of years in exchange for the principal they used to purchase the bond, which will be returned in full by the debtor at the end of the deadline.

Let’s clarify everything with a example on an Italian government bond of our imagination: let’s assume that the Italian State needs money from a source other than tax revenues and thus chooses to expose itself to the financial market. In practice, it is as if the State rewarded those who lend money for a certain period of time with an interest rate. The longer the time period is, the higher the interest rate paid annually. Therefore, those who lend money to the state for 5 years will receive a lower annual interest rate than those who lend money for 10 years.

The State then issues bonds, "pieces of paper" where it is specified that the creditor will receive an annual interest rate, commonly known as a "coupon" paid to the creditor as a "risk premium" paid annually for the entire duration of the obligation. We therefore assume that the State, the debtor, offers bonds that yield 4% per annum for 10 years. This is a 10-year government bond, what is defined Btp (Multi-year Treasury bill) with a yield of 4%.

The first creditors arrive who want to buy these securities and there are those who will buy securities for € 1000, those for € 10,000, those for € 100,000 (this is an example that serves to understand how a bond works). In this context, therefore, the State collects the money of creditors and at the same time becomes a debtor towards them then detaching the coupons annually. At the end of the 10 years, the State will return the initial capital to the creditor together with the last annual coupon. Attention, we repeat that this was an example to understand the basic theoretical functioning of a bond. Now let’s see some clarifications and make everything slightly more complex.

Bonds, the primary market and the secondary market

Let’s imagine the situation as before and bring it to the real world. The state offers titles, but to whom? First of all, an auction is promoted where authorized entities can buy these newly issued bonds and from there, based on the demand for the bonds, an interest rate is established. Imagine that banks participate in this auction, institutions that have a lot of money at their disposal and that consequently will want to grab these securities.

Strong demand determines the price and yield of bonds: the more banks want those bonds, the more the yield on them falls. From here arises the first main relation of bonds, ie a higher demand corresponds to an increase in price and a decrease in yield. If demand is low, the government will have to make its bonds more attractive and therefore will increase yields and lower prices.

A rise in prices corresponds to a fall in yields and vice versa, the main rule of the bond market. Once purchased on the primary market, these securities will be placed on the secondary market, resold and relocated to the financial markets and therefore to the public of savers, investors or traders. On the secondary markets, the price will start to fluctuate, as will the yields and here is where traders and investors meet.

The bond investor

Investing in bonds involves the calculation of yields within the expected maturity. To give an example, if I invest 100 on a 10-year bond that yields 4% and which has a price of 100, we will have a return of 40% after 10 years on our capital, precisely 4% at year. This yield is obtained only and exclusively if the security is bought and brought to maturity, that is, it is not resold during the term of the bond. This approach is a classic of portfolio managers and savers who decide to invest part of their capital to avoid the impoverishment of their finances due to inflation.

Making a very small reference to inflation, it is necessary to know that inflation is fundamental in calculating the real return of an investment as the increase in prices in the economy corresponds to a decrease in the real returns on real investments. To give an example with the ten-year bond above, if we have an average annual inflation of 1.5%, our real return will be 2.5% per year (4% -1.5%). In practice, at maturity we will certainly have that 40% but due to inflation it will correspond to a real yield of 25%, net of our loss of purchasing power. We must always think that the prices of 10 years ago are lower than the current ones.

So, if the bonds are matured and our debtor doesn’t go bankrupt (let’s hope the state never fails), we will always have our capital plus coupons. But what if our own stock yields 6% after 3 years? Can we resell it and buy the same stock? Yes, but we will have a capital loss because if the yield has increased, its price has fallen, it has gone below 100. In this case, it is therefore advisable to keep the stock in the portfolio and avoid losses.

Bond trading

The bond trader associates a specific risk with the yield offered by the bond, so he is interested in the price trend of the bond to speculate on price changes. In the case of the first a trader would have “sold short” the bond which yielded 4% and then bought it back at 6%, earning on the downward price difference.

To make these operations, the bond market is treated with the same approach as a trader who operates on Forex, commodities or indices. This is a sector, that of Fixed Income, very particular as the trader, in addition to having the difficulty of analyzing the price trend of a bond, a not very volatile market, also has the task of analyzing the correct premium at risk derived from returns. In practice, it uses both information to decide its operations, be they short, medium or long term.

Is it better to invest or trade?

The answer is, as always, "it depends". Obviously, if you have a saver approach, bonds represent a good tool to have certain returns (on paper) within a certain deadline. If, on the other hand, you have a more inclined approach to risk management, the Fixed Income market requires strong specialization so much so that private traders on this market are truly a minority compared to traders who operate on indices or Forex. .

In recent years, thanks to the liquidity of central banks and yields close to 0%, the fixed income market has been mostly negotiated by professional traders, traders who are now returning to the market ready to act as a counterpart to many investors, greedy for yields that have finally returned to the market after years of rates reduced to 0% and in some cases negative (see the German Bund). The bond market is returning with excellent yields, but will that be enough to cover inflation in the long run? Will they still go up or have they already reached acceptable levels? We will see this together over the next few weeks.

Original article published on Money.it Italy 2022-10-25 08:57:00.
Original title: Obbligazioni, fare trading o investire?