Top 5 Bond Trading Methodologies
Including bonds in your portfolio is one of the best ways to add diversification and reduce the risks involved with volatile assets like stocks. Bonds provide a predictable rate of return and carry a higher return than saving in banks and certificates of deposits. And if held to maturity, you get back the principal.
There are different methods of investing in bonds. Your choice will depend on your risk tolerance. Like most investments, the more risk involved, the higher the return. Here are the top five.
These are the safest forms of bonds. They are issued by the national government of a country to fund its operations. Government bonds are denominated in the country’s currency. When the bond is issued in a foreign currency, it is known as a sovereign bond.
Government bonds are the most stable type of bonds because they are guaranteed by the national government, which can easily raise taxes or print money to redeem the bond. But this low risk also means that they come with the lowest return.
2. Working with Corporate Bonds
Corporate bonds are issued by private and public corporations. Their purpose is to raise money for business operations, such as exploiting new business ventures. They are generally riskier than government bonds but pay higher rates.
Corporate bonds can be classified as investment-grade or speculative-grade. Speculative-grade bonds have a relatively lower credit rating than investment-grade bonds. They carry a higher risk of default, which makes them higher-yielding.
3. Investing in Municipal Bonds (“Muni Bonds” or “Munis”)
These are bonds issued by government entities like states, municipalities, or counties to fund public work, such as parks and libraries. They are tax-free at the federal level, which makes them attractive.
Municipal bonds can be classified as:
- Conduit bonds
- General obligation bonds
- Revenue bonds
General obligation bonds are not secured by revenue generated from a project. They can be payable from general funds or dedicated property taxes. Revenue bonds are secured by revenue from a specific project or another source. Conduit bonds are issued on behalf of private bodies such as hospitals. The borrowing entity is responsible for making repayments to the investors.
4. Investing in Emerging Market Bonds
These are bonds that are issued by governments and companies in developing countries. Due to the high risk involved, they carry very attractive yields.
Emerging market bonds come with special risks, such as currency fluctuation as well as economic and political risks. Latin America and Asia are examples of developing economies.
5. Investing in Inflation-linked Bonds
These are government bonds whose principal is adjusted regularly based on changes in the inflation rate. This then provides an inflation—adjusted or real return.
These bonds provide protection against short-term inflation. They lose more value when the real interest rates rise.
It’s easy to ignore the many advantages that bonds carry. They may not come with the excitement of unpredictability that other assets have, but the diversification they add to your portfolio cannot be ignored.
If you are more risk-tolerant, you can invest in speculative-grade corporate bonds or emerging market bonds. If you are a more risk-averse investor, try government bonds, investment-grade corporate bonds, and municipal bonds.