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How to Make money by Trading Bonds?

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Trading Bonds

As a fixed-income security, Investment Bonds are traditionally a relatively safer way to add to your regular income. But this also means that the yield on them is pretty low -usually around 8% to 9% – which means there is a lot of waiting involved till the bond matures. But like other security investments, they can be traded and this means less waiting around to make money. Let’s see how you can make money by trading bonds in the Indian market.

Make Money by Trading Bonds

One of the most effective ways of making money by trading bonds is to buy long term bonds with longer maturity periods and selling them before their maturity ends by taking advantage of the increase in the bond’s value. There are three key points on which this strategy rests:

  • Longer term bonds have higher interest rates than short term bonds
  • The value of long term bonds rises over time
  • Trading corporate bonds is advantageous over government bonds because the gaps in the longer and short term bonds is wider

There is an inverse ratio relationship between the interest rates on a bond and its value. As the bond approaches maturity, the interest rate gradually decreases whereas its principal value increases. This is more pronounced in long term bonds than short term ones. So why would you sell a bond if its value is increasing? Let’s understand this seemingly counter intuitive approach through an example.

Let’s assume that IDBI has a bond valued at Rs. 1000 at 8% interest rate which matures in 5 years. Now through previous yield trends of the bond, let’s say that the interest rate drops by 0.2% annually while the value of the bond rises by Rs. 100.

Now let’s consider another shorter term bond of say HUDCO valued at Rs. 1000 which matures in 2 years with an interest rate of 7%.

If you would hold on to the HUDCO bond till maturity, you would make a profit of Rs. 140. Alternatively, if you sold the IDBI bond in 2 years, you would make a profit of Rs. 200. This is clearly more lucrative than holding a shorter term bond to maturity.

Of course, the numbers and trends in this example are over simplified here and predicting interest fluctuations is not as easy. But studying a yield curve which maps the expected yield against time could make it easier.

What’s the Catch?

The biggest risk involved in this trading strategy, is the overall rise in market interest rates. An overall interest rate rise means the par values of the bonds will fall. In such a scenario, holding a short term bond till maturity would be definitely more profitable. Bond trading experts like Bill Gross recommend this ‘rolling down the yield curve’ method of trading. But you need to be wary of the market. As always, like any other security investment option, keep a close eye on the OTC trade tables and study market trends at least on a weekly basis.

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2 COMMENTS

  1. It seems to me like the bonds value increase over time will remain the same due to declining interest rates – like an inversely proportional relationship. Sounds like the key to making money trading bonds is to choose ones that increase in value more than other bonds… so how can we determine this?

  2. The rate of interest for investment bonds is 8% -9%. But their value increases when the time perid is longer, But , then it is a better option to invest in short term bond because of the market interest rate which is not stable. So as usual a little awareness and studying of market trends before investing is required.

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