Unfolding Fixed-Income: Bonds, Trading Strategies and Recent Developments
Greetings and welcome to this knowledge-sharing series!
In today’s article, let’s dive deeper into the fixed-income market that has gained recognition over the past year or two, especially with interest rate hikes.
For those seeking clarity into fixed income, it involves dealing with debt instruments such as bonds and treasuries. These instruments have a principal, an interest component (could also be referred to as a coupon), and a duration to maturity. On a high level, we might say that the price of a bond should correlate only with an interest rate hike. While that is true, in this article, let’s explore a little more in-depth how economic factors impact bonds and how fixed-income traders, at least in theory, navigate these changes.
Pricing of fixed-income instruments
Focusing only on bonds for now, bond prices are impacted by changes in interest rates and the duration to maturity.
To understand these correlations, let’s understand bond pricing. Bonds are priced based on the concept of ‘present value of future cash flows’. All the coupons and principal to be paid over the years are discounted back to the present day and summed together. To discount them back, the rate used is the prevailing interest rate. Based on the number of years i.e. duration of bond maturity, the interest rate forecast for those years is taken from the ‘yield curve’ to discount the coupons and principal payment to get the price of the bond. (Side note: yield curve, in simplest terms, can be assumed as the series of interest rates from the present day to the next few years) Hence, when we hear things like ‘yield curve has steepened’ it means that the discount rate for our bonds is increasing over the years. Therefore, the longer the maturity date, the lower will be the price of the bond and vice versa! This makes the duration an equally important factor as interest rate in bond trading.
Based on the above explanation, if interest rates rise, the discount rate is rising! This means that existing bonds in the market must reduce their price to cater to this discount rate. This negatively impacts the existing bondholders. On the other hand, new bonds issued with this high interest rate look attractive because they can offer a higher return.
Bond pricing can also be correlated to the credit rating and credit risk alongside duration. The risk of credit rating fluctuations in the longer term is higher and hence, could make long-duration bonds sensitive to changes in credit ratings.
Bonds are just one of the fixed-income instruments but help in understanding how pricing works in the fixed-income world.
Fixed income trading
Again let’s understand this using bonds. Bond trading is a very interesting subject to learn about because of its complex nature. Based on the above explanation, you must have figured out that duration plays a vital role in bond trading, and rightly so! Here’s a list of a few classic, theoretical ways bonds are traded in the market:
1. Purely based on credit risk: Traders may track credit spread information (which shows credit risk anticipation). If the spread is widening, credit risk in the longer term is increasing. To mitigate the risk, holding a short-duration bond would make sense.
2. Purely based on yield curve/interest rates: If the yield curve is steepening i.e. longer-term interest rates are rising more than short-term rates then buying long-duration bonds makes sense. And if the curve is flat or inverted then the short term becomes attractive.
3. Income stability: Usually duration bonds give a more stable income source since, in simple terms, they have enough time to deal with the volatility and hence give a steady amount of coupons each year which can be considered as a kind of normalised throughout the bond.
These above strategies are simplest and one dimensional in my view. But bond traders are not always individuals or companies that care about interest rates solely. Some trade bonds for the safety of the principal, some as a hedge, and much more! Simply buying and holding a bond may not always be smart. In that case, as we have learnt in F&O, there are multiple combinations of bonds that traders work with together to get the best possible outcome! Following are some of the most classic, classroom-taught strategies to know:
1. Barbell strategy: In this case, the trader buys both short-term and long-term bonds. If we expect interest rates to fall in the future then, short short-term bonds may give liquidity and predictable income, while long-term bonds can give capital gain (increase in principal payment) if the interest rate (i.e. discount rate) declines. This strategy can also be used with a floating rate component. Floating rate means that the bonds adjust to the changes in interest rates which can be used as a hedge against interest rate risk.
2. Ladder strategy: If the trader is uncertain of interest rate fluctuations in the future and wants to take less risk, then he can buy bonds of different maturities across a few years and reinvest if needed after maturity. For example, he could hold one 2-year bond, one 5-year bond, and one 10-year bond. This way he covers interest rate fluctuations across all durations. For example, when the 2-year bond matures, he can evaluate the market dynamic and reinvest in some bonds again to keep the strategy going.
There are many more strategies and complex instruments fixed-income traders use to maximize returns with minimum risk. But bonds are an easy way to train the mind in understanding the rationale in fixed income trading which differs slightly from the popular equities trading.
Recent developments in the fixed-income markets
In the first two weeks of this year, Europe’s bond market has seen a record start with €195 billion ($213 billion) of syndicated debt placements, surpassing last year’s tally by nearly 10%. This is good news for governments and companies seeking buyers for significant debt in the coming months. The diversity of issuers is notable, including top-quality names and even lower-rated credits venturing into high-yield territory. Notable deals include AXA SA’s €1.5 billion restricted tier 1 perpetual deal and Volkswagen AG’s three-tranche deal. Despite the high volume, there’s no sign of trouble, as issuers maintain reasonable pricing strategies. The surge in these deals is expected after the earnings reporting season, ensuring a busy period ahead.
Working in fixed income involves understanding the workings of a fixed income instrument, all the economic and non-economic factors that have a direct or trickle-down impact on your instruments, and strategizing creatively to get the best outcome. Fixed Income involves way more complexity, concepts, and strategies than what’s mentioned above.
Hope this article has given you a brief overview of the fixed-income market and its workings.
Stay tuned for more such articles every week!
Sources: Financial Times, Bloomberg, Desktop research
Disclaimer: This article provides educational content on fixed-income trading, aiming to simplify complex concepts for novice readers. It does not constitute financial advice, and readers should conduct their research or consult financial professionals before making investment decisions. Market conditions can change, impacting the performance of the strategies discussed. The recent developments section is based on publicly available information and may not capture all market nuances.
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