Bond Basics Part 3: Buying, Selling and Strategy
A useful guide to the world of bonds...
Be sure to read the rest of the Bond Basics series:
Buying and Selling Bonds - The World of the Opaque
- What is the difference between trading stocks and bonds?
- Stocks are "transparent." In other words, in most liquid stocks, we can all buy shares at the same price, if enough are offered; or sell, if enough are bid for. Please click here for a detailed explanation of this concept.
- Bonds are much more complicated to trade as they are traded for the most part in the "over the counter" market, or third market. Generally speaking, Treasury bonds and notes have the most transparency and efficient trading characteristics, junk bonds and derivative securities offer the least transparency and efficiency. The big difference for retail investors and institutional investors is that retail generally only has one outlet to buy and sell (a cash account at a brokerage firm) while institutional investors have multiple outlets (there are thousand of dealers that specialize in various types of securities). It is why more and more individuals (with enough capital) are turning to professionals to handle their bond portfolios.
- What is the best way to be sure you are getting the "best execution?" I suggest you visit http://www.investinginbonds.com/; there you can find what the "big boys" or institutions are trading for, so you don't get hurt. I have found in a world of low yields that most of good performance can be attributed to efficient trade execution.
Price Movement of Bonds
- Generally, bond prices move in the opposite direction of yields.
- Generally, longer term bonds are more volatile to changes in interest rates than short term bonds.
- Bonds move in the opposite direction of rates for the following reason: Imagine a bond as a "piece of principal" with a bunch of coupons or interest payments attached to it. The coupon of the bond, for this example, is constant. If rates rise, that coupon is worthless to a new buyer, hence, a decline in price to a discount. Vice versa, if rates fall, the coupon is worth more to a new buyer and they will pay more for the bond or a premium.
- Why are longer term bonds more volatile than short-term bonds? Longer term bonds, simply have more coupons attached to the bonds, so there are more cash flows that are affected. Short-term bonds decrease in maturity every day that passes, so they become less volatile each day.
- See the chart below, depicting this relationship.
Maturity Versus Duration
- Duration is a distinctly different concept than maturity. Duration, simply defined, is "the weighed average maturity of the securities cash flows, when the present values of the cash flows serve as the weights." The greater the duration of a security, the greater its percentage price volatility. Portfolio managers use duration to measure the "lever" of volatility of their portfolios given various interest rate movements. In real life, for each instantaneous 100 basis point move in rates, a security will move in percentage the amount of its duration. So a bond with a 10 year duration, would move 10% depending on if rates rose or fell (remember, it is an inverse relationship). Long term municipals have some of the longest durations. Further, a zero-coupon bond (one with no cash flows) duration equals the maturity.
- Maturity is much more simple – it is just the date the security matures.
Types of Bond Investing Strategies
- Laddering: This is the simplest of all bond portfolio strategies. One simply buys bonds maturing every month or year. For example, an investor might buy a bond maturing in each of the next ten years. The principal risk is if rates are lower as bonds mature, known as "reinvestment risk." Conversely, if rates are higher as bonds mature, one can reinvest at the higher rates available at that time.
- Barbell Strategy: As defined by Bloomberg, this is a "portfolio strategy" in which maturities of included bonds are concentrated at two extremes. In this case, the investor might buy bonds that mature at both ends of the maturity spectrum, say 6 months and 30 years.
- Bullet Strategy: As defined by Bloomberg, this is a strategy in which a portfolio has maturities that are highly concentrated at one point of the yield curve, say 5 years for example.
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