When companies or other entities such as governments need to raise money for new projects, fund operations, or refinance existing debts, they may issue bonds directly to investors. Many corporate and government bonds are publicly traded on exchanges.
Investors who hold bonds may adjust their portfolios to protect or profit from the market due to changes in interest rates, commodity prices, or company setbacks.
Key Takeaways
- Investors trade bonds for profit and protection.
- Investors profit by trading up to a higher-yielding bond or benefit from a credit upgrade.
- Bonds can be traded for protection where traders pull money from bonds exposed to industries that experience setbacks.
1. Yield Pickup
Investors trade bonds to increase the yield on their portfolios. Yield is the total return investors expect to receive and maximize if they hold a bond to maturity.
For example, investors may own investment-grade BBB bonds in Company X yielding 5.5%. They see that the yield on similarly rated bonds in Company Y traded at 5.75%. If the credit risk is negligible, selling the X bonds and purchasing the Y ones would net a spread gain or yield pickup of 0.25%.
2. Credit-Upgrade Trade
Three main providers of credit ratings for companies and country debt include 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 swings in these credit ratings can present a trading opportunity.
The credit-upgrade trade can be used if an investor anticipates that a certain debt issue will be upgraded. When an upgrade occurs on a bond issuer, the price of the bond increases and the yield decreases. The investor tries to capture this anticipated price increase by purchasing the bond before the credit upgrade.
3. Credit-Defense Trade
In times of increasing instability in the economy, certain sectors become more vulnerable to defaulting on their debt obligations than others. A trader can adopt a more defensive position and pull money out of sectors expected to do poorly. 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.
Signs that a certain industry will become less profitable in the future can trigger credit-defense trades within a portfolio. Increased competition in an industry due to reduced barriers to entry can cause increased competition and downward pressure on profit margins for all companies within that industry. This can force weaker companies out of the market or declare bankruptcy.
Bonds are typically grouped and rated as investment grade or high-yield.
4. Sector-Rotation Trade
The sector-rotation trades seek to re-allocate capital to sectors expected to outperform relative to an industry or another sector. One strategy is to rotate bonds between cyclical and non-cyclical sectors, depending on where the investor believes the economy is headed.
During the U.S. recession that began in 2007, many investors and portfolio managers rotated their bond portfolios out of cyclical sectors like retail, and into non-cyclical sectors like consumer staples.
5. Yield Curve Adjustment
The duration of a bond portfolio is a measure of the bond’s price sensitivity to changes in interest rates. High-duration bonds have a higher sensitivity to changes in interest rates, and vice versa, with low-duration bonds. For example, a bond portfolio with a duration of five years 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 a bond portfolio to gain increased or decreased sensitivity to interest rates. In the 1980s, when interest rates were in the double digits a trader who predicted the steady decrease in interest rates in the following years increased the duration of their bond portfolio in anticipation of the drop.
What Is the Correlation Between a Bond’s Price and Interest Rates?
The price of bonds is inversely correlated to interest rates—meaning a decrease in interest rates increases bond prices, and an increase in interest rates results in a decrease in bond prices.
When Can a Bond Trader Increase Duration?
Increasing the bond portfolio’s duration in anticipation of a decrease in interest rates can be one option for a trader.
When Do Credit Upgrade Trades Occur?
Credit upgrade trades typically occur around the cut-off between investment-grade ratings and below-investment-grade ratings. For example, a jump up from junk bond status to investment grade can result in significant profits.
The Bottom Line
Investors may juggle their bond portfolios just like their stock portfolios in response to changes in market conditions or a company’s financial health. Changes in interest rates, commodity prices, or corporate bankruptcy may trigger an investor to review their bond holdings.
