Bond trading has a 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.
Trading Bonds: Low Profile but Very Important
An understanding of the bond market and bond trading is essential to proper investing. Bonds and trading bonds in the bond 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 yield 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
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.
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.
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.
Why Trade Bonds?
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.