How are bonds traded?

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An understanding of the bond market and bond trading is essential to proper investing. How bonds are traded in the market are confusing to most people but they are very important to the economy and the prevailing level of interest rates.

Importance of Trading Bonds

Trading bonds happens many thousands times a day and is an important part of global economic markets. The bond market is far bigger than the stock market and central banks conduct monetary policy in the bond markets. When buyers and sellers are trading their bonds, they dictate the yields of the various types of bonds they are trading. This in turn sets the price of credit in the economy.

Joe and Suzy Q Public might not understand bond trading but the yields in the bond market set the interest rates on their mortgages, GICs, car loans and other types of consumer loans.

Bonds trade anywhere that a buyer and seller can strike a deal. Unlike publicly-traded stocks, there’s no central place or exchange for bond trading. The bond market is an “over-the-counter” market or OTC market, rather than on a formal exchange. Convertible bonds, some bond futures and bond options are traded on exchanges.

Trading Bonds: Dealers and Investors

Bond Dealers

While investors can trade marketable bonds among themselves, trading is usually done through bond dealers, or more specifically, the bond trading desks of major investment dealers.

These dealers are at the center of a vast network of telephone and computer links that connect all the interested players. They also have traders responsible for knowing all about a group of bonds and quoting a price to buy or sell them, or “making a market” for bonds.

Dealers provide “liquidity” for bond investors so that those investors can buy and sell bonds more easily and with a limited concession on the price, but dealers can also buy and sell amongst themselves, either directly or anonymously through bond brokers.

In all bond trading, the goal is to take a spread between the price the bonds are bought at and the price they are sold at. That spread is how bond dealers make (or lose) money.

Bond trading became very lucrative before the credit crisis, when investment dealers used their banking capital to fund huge inventories of bonds and do mostly proprietary trading. This didn’t end very well, as bond prices fell during the crisis and dealers took huge losses on their inventories. Many banks had to be bailed out by governments and this is why banking regulators now severely restrict proprietary trading activities.

Bond Investors

Trading bonds also involves financial institutions, pension funds, mutual funds and governments from around the world.

These bond investors, along with the dealers, make up the “institutional market,” where large blocks of bonds are traded. A trade involving $1 million worth of bonds would be considered a small ticket in the institutional market. There’s no size limit in this market, where trades worth $500 million or $1 billion at a time can take place.

There’s also no size restriction in the “retail market,” where individual investors buy and sell bonds with the bond trading desks of investment dealers, but the size of those trades is usually under $1 million.

Bond Market Terminology

Here are some of the key concepts a bond trader must be familiar with on order to do his job:

CouponThe percentage interest to be paid on a bond in the course of a year. The interest is usually payable semi-annually, although it can also be payable monthly, quarterly, and annually.

MaturityThe date the bond will be redeemed or paid off.

PriceThe quoted price is usually based on the bond maturity at a price of par, or 100.00.

YieldThe term “yield” usually means “yield to maturity.” The yield to maturity takes into account the coupon payment, and considers whether the bond is maturing at a different price than its current price.

BidThe price at which the trader will pay for a bond.

Offer (Ask)The price at which the trader will sell a bond.

Bid-offer spreadThe price difference between what the trader will buy a bond at and the price at which the trader will sell a bond. The difference on highly liquid and tradable government bonds is usually only a few cents.

Basis pointsA basis point is a hundredth of a percentage point. For instance, if a yield moves from 5.5% to 5%, it has moved 50 basis points.

Spreadover governmentsNon-federal government bonds are often quoted on the basis of a yield spread over a comparable government bond. A corporate bond with a similar coupon and maturity date could easily be 100 basis points higher in yield than a federal government bond. Traders often bid and offer on a spread basis.

“Bells and Whistles”What this refers to are special features for specific bonds. For example, a bond may mature on June 1, 2008, but there may be a special feature that allows the issuer to “call” the bond back on an earlier date, known as the call date. There are many other such special features.

Bond auctionsFederal governments in North America have moved to a system of auctions to sell their bonds to investors. Most bond dealers are allowed to bid at the auctions and then re-distribute the bonds to investors.

New issuesMost other governments and corporations use a different system of distributing new issues, namely offering them to investors through bond dealers. The bond dealers earn a commission for distributing the bonds to investors. The offering can be on a fixed price basis, or on the basis of a fixed yield spread to comparable federal government bonds.

Book-based bondsIn recent years bonds have gone “book-based,” meaning that the bonds are lodged with a central trustee and do not physically move from there. Instead, the dealers and institutions have accounts set up with the trustee, and when a bond trade takes place, the buyer’s account is credited with the bonds, while the seller’s account is debited. Most government and corporate bonds are book-based and investors are discouraged from taking physical possession of the bonds.

Why Trade Bonds?

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A bond trader at an investment dealer seeks to make a profit on his “trading book”. The more money he makes, the greater his bonus. That is why traders have high transactions volumes – because the more they trade, the more money they will make.

A hedge fund trader will trade similarly to an investment dealer but use more “leverage,” or borrow money against the bonds the fund owns. Hedge fund traders also make many trades to maximize their profits.

A “Buy Side” bond trader usually holds her bonds for longer periods, given the long-term nature of their portfolios. Insurance companies and pension funds have very long-term liabilities and need to always hold bonds.

Trading Bonds: Low Profile but Very Important

Bond trading is lower profile than stock trading but it is more important. Bond dealers and bond investors alter their portfolios in light of changing market conditions to make a profit and/or maximize the return on their portfolios. The overall effect of all this bond market activity is the prevailing level of interest rates in an economy, which affects almost all types of credit and lending.

Realtime bonds chart in amibroker