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This article outlines the different aspects and outlets involved in trading bonds as well as the markets in which they are applicable and relevant terminology.

Importance of Trading Bonds

Trading bonds is an important aspect of global economic markets. Bonds generally can trade anywhere in the world that a buyer and seller can strike a deal. There is no central place or exchange for bond trading, as there is for publicly traded stocks. The bond market is known as an “over-the-counter” market, rather than an exchange market.  However, bond futures, and some types of bond options, are traded on exchanges.

Trading Bonds: Dealers and Investors

Bond Dealers

While investors trading bonds can trade marketable bonds among themselves whenever they want, trading is usually done with bond dealers, more specifically, the bond trading desks of major investment dealers. The dealers occupy center stage in the vast network of telephone and computer links that connect the interested players. Bond dealers usually “make a market” for bonds. What this means is that the dealer has traders whose responsibility is to know all about a group of bonds and to be prepared to quote a price to buy or sell them. The role of the dealers is to provide “liquidity” for bond investors, thereby allowing investors to buy and sell bonds more easily and with a limited concession on the price. Dealers also buy and sell amongst themselves, either directly or anonymously via bond brokers. The objective is to take a spread between the price the bonds are bought at and the price they are sold at. This is the main way that bond dealers make (or lose) money. Dealers often have bond traders located in the major financial centers and are able to trade bonds 24 hours a day (although not usually on weekends).

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, comprise the “institutional market,” where large blocks of bonds are traded. A trade of $1-million-worth of bonds would be considered a small ticket. There is no size limit, and trades involving $500 million or $1 billion at a time can take place. Similarly, there is no size restriction in the “retail market,” which essentially involves individual investors buying and selling bonds with the bond trading desks of investment dealers. However, the size of trades is usually under $1 million.

Bond Market Terminology

The following review of terminology is from the point of view of a bond trader. Trading bonds involves knowledge of these terms.

Coupon

The 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.

Maturity

The date the bond will be redeemed or paid off.

Price

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

Yield

The 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.

Bid

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

Offer(Ask)

The price at which the trader will sell a bond.

Bid-offer spread

The 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 points

A 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.

Spread over governments

Non-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 auctions

Federal 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 issues

Most 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 bonds

In 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.

 

Implications for Trading Bonds

Trading bonds is less common than trading stocks, but is an equally important aspect of investment practices. Bond dealers and bond investors can exchange bonds to maximize their returns in much the same way one might a stock portfolio in light of changing market conditions.

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