Bond CFDs Trading Strategies

Bond CFDs provide traders with exposure to the bond markets without having direct ownership of bonds. They allow traders to speculate on the price action of an underlying bond market, make trades on margin, and take both long and short positions.

But first, what are bonds? Well, bonds are debt instruments that provide investors with fixed income. They are a regulated security through which governments and companies raise funds from the investing public.

By purchasing a bond, an investor is essentially making a loan to the bond issuer; in return the investor is entitled to the interest promised by the bond issuer, along with the repayment of the loan by the maturity date of the bond. The interest rate on a bond makes up the return on investment for holders of the bond.

Here’s a simple example to illustrate how bonds work.

Let’s assume the US government issues a 10-year bond with a coupon rate of 3% per annum. An investor who purchases one of these bonds at USD 10,000 and holds the bond till maturity will receive:

• The coupon rate: 3% x USD 10,000 = USD 300 per year for 10 years
• The face value of the bond at maturity: USD 10,000

Bonds are tradeable on the secondary market. This means that bondholders seeking higher returns can choose to sell their bonds to other parties.

This buying and selling activity is what generates price action on the secondary bond markets–this is the same price action that bond CFD traders may speculate on.

Thus, it is important to distinguish between purchasing bonds in order to earn interest, and trading the price action of the secondary bond market. The following table spells out the difference between the two.

Interest Rate Decisions by Central Banks

Bond prices and interest rates share an inverse relationship. When interest rates rise, bond prices tend to drop; and when interest rates fall, bond prices tend to increase.

This is because bonds are issued with yield equal to or slightly higher than the prevailing interest rate. When interest rates fall, previously issued bonds with a higher yield become more attractive. Bond investors compete to buy these older bonds, and the increased demand drives up prices.

The opposite happens when interest rates rise. Newly issued bonds have greater yield than older ones. Thus, older bonds have to be priced lower in order to match the higher yields of newer bonds.

Hence, the key to understanding this inverse relationship between bond price and interest rate is yield. The yield of a bond is calculated by dividing the annual coupon payment of a bond by its price. The annual coupon payment remains fixed throughout the bond’s duration, leaving only the yield and the price to change.

Here’s an example. Consider a 1-year bond with a par value of $1,000, priced at $950. This means you can pay $950 for the bond and redeem it at par value $1,000 upon maturity in one year’s time. Thus, the annual coupon payment is $50 ($1,000 - $950).

The yield on this bond would therefore be:

• (1000 - 950)/950 x 100 = 5.26%

If a newer bond is released that has a yield of 10%, investors would prefer the newer bond. To remain competitive, the older bond described above would need to lower its price to around $908:

• (1000 - 908)/908 x 100 = 10.13%

Note: These examples are for illustrative purposes only and do not represent actual returns or trading outcomes.

Inflation and Economic Data

Recall that central banks control interest rates in order to stimulate economic activity, or to slow it down. The latter is necessary when inflation becomes too high; this causes central banks like the US Federal Reserve to hike interest rates, which makes borrowing more expensive, leading to lower levels of economic activity.

With less money in the financial system, there is less spending to go around, causing prices of goods to reduce, or at least not increase that quickly. This brings down the inflation rate. Most economists agree that an inflation rate of around 2% is ideal for healthy economic growth, and central banks are motivated to raise interest rates and keep them there until inflation reaches or approaches this level.

Besides inflation, bonds can also be affected by other macroeconomic data, especially those concerned with economic health. Some examples are GDP growth forecast, employment figures, corporate earnings, and consumer spending levels.

Additionally, geopolitical factors that can impact economic strength will also affect bond prices. For example, increased hostilities in key oil-producing regions such as the Middle East can cause oil prices to go up, leading to several negative effects including higher inflation, slower growth, and more expensive energy imports.

When economic data or geopolitical factors worsen market outlooks, investors tend to retreat from riskier assets such as equities in favour of bonds, which are considered safe haven assets that provide risk-free returns. This is exacerbated if central banks raise interest rates to combat high inflation, increasing bond yields and making them even more attractive.

Credit Ratings and Default Risk

Bonds are debt instruments, and carry credit ratings. These are a measure of default risk, which is how likely the bond issuer will pay back the full par value of the bond at maturity, or meet the stipulated coupon payments.

The default risk of a bond depends on who issued it. Government bonds from stable, advanced economies generally have high credit ratings, meaning there is a low likelihood of the bond issuer defaulting on bond repayments.

On the other hand, corporate bonds, which are issued by private companies, can have wider variance in default risk, and thus credit ratings. This is because companies are more susceptible to negative market developments, compared to governments.

Bonds are rated by rating agencies. Some well-known bond-rating agencies include Standard & Poor’s, Moody’s and Fitch Ratings. Depending on how well they rate, bonds can be graded anywhere from AAA to D.

Whether government or corporate, bonds that are rated from AAA to BBB are considered investment-grade bonds, offering low risk and low yields.

Bonds that have a rating lower than BBB are considered as speculative-grade, or junk bonds. These bonds carry considerably higher risk, but to make up for it, they offer higher yields. Higher-yield bonds often carry increased risk, and their prices may be more volatile compared to investment-grade bonds

Note that bond credit ratings may be altered over time, depending on how well the bond issuer meets the evaluation criteria of the rating agencies.

Government Bonds

Government bonds are among the most popular types of bond CFDs to trade, on account of their popularity and high stability. They are issued by governments to finance public initiatives and projects, and are some of the lowest-risk investments in the market.

Importantly, government bonds are sensitive to macroeconomic and geopolitical events, creating additional trading opportunities for well-prepared traders. Some of the most sought-after government bonds are those issued by governments of leading economies. These include:

• US Treasury bonds. Issued and backed by the US government, US Treasury bonds are available in a wide variety of maturities, spanning from 2 years to 10, and even 30 years. These bonds are popular among traders who want to trade on US Fed interest changes, as they are tightly matched to interest rates.
• UK gilts are the British counterpart US Treasury bonds. They are issued by the UK government in various maturities spanning 10 to 30 years, and are driven by the monetary policies of the Bank of England. Traders can use gilts to speculate on the pound sterling, UK inflation trends, Brexit-related developments and other major drivers of the British economy.
• Japanese Government Bonds (JGBs) offer a more stable bond CFD for those seeking to hedge against risk with lower volatility. This is mainly due to the long-standing fiscal policies of the Japanese government, which has historically kept interest rates near zero.

Corporate Bonds

Besides issuing shares, another way for companies to raise capital is to issue corporate bonds. Compared to government bonds, corporate bonds have lower liquidity, and may not be as widely available.

Corporate bonds tend to have lower credit ratings as companies are simply more vulnerable in an economic downturn. With higher default risk and lower liquidity, corporate bond CFDs may offer more volatile price action attractive to traders with more aggressive risk appetites.

It may be rare to find corporate bond CFDs of single companies; bond indices and bond ETFs are more readily available, offering exposure to a range of corporate bonds at once.

Some of these include:

• iBoxx Indices, which track specific bond market segments such as investment-grade corporate bonds, non-financials bonds, or inflation-linked indices.
• Bloomberg Barclays Bond Indices, which offers exposure to aggregate bond performance across specified market sectors.
• Bond ETFs that allow traders to trade the price performance of overall bond markets. These include the iShares Core US Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market ETF (BND).

Mortgage Bonds

Mortgage bonds are debt instruments issued on the cash flow of a pool of mortgages. They are backed by real estate holdings–or the mortgages attached to them, to be exact–which means that any defaults can be made good on through the seizure and sale of properties.

Additionally, mortgage bonds often comprise several mortgage pools. Should one mortgage default, the others in the pool can still continue to provide payouts to investors.

Mortgage bonds are susceptible to interest rate changes, which mean mortgage bond CFDs can offer another avenue for traders to speculate on interest rate changes. Another risk unique to mortgage bonds is prepayment risk. As homeowners may repay their mortgage early, this means mortgage bonds may not have fixed maturity dates; this could manifest as unexpected price changes.

Convertible Bonds

Convertible bonds are hybrid securities that combine both fixed income and equity. As their name suggests, convertible bonds can be converted to a predetermined number of shares of the company–this is commonly at the sole discretion of the bondholder.

This unique feature of convertible bonds gives investors a rare advantage. Should the company do well and the share price rises, the bondholder can convert their bonds to shares and benefit from the stock’s price appreciation. If, however, the share price remains under expectations, the bondholder can continue holding on to their bonds to collect coupon payments.

Because convertible bonds have less stable redemption dates (as bondholders can convert them at any time), the secondary market for such bonds tends to be more volatile, especially around corporate earnings announcements. CFD traders seeking to trade convertible bonds should pay attention to company performance, on top of all the other factors that also impact bond markets.

Hedging

Hedging is a technique to limit or offset market risk in your portfolio. The aim here is to use a bond CFD to hedge against potential losses in your bond holdings.

For instance, if interest rates increase, bond prices will drop. A bond trader who anticipates this may choose to trade a bond CFD, taking a short position. If the market does indeed fall, they could offset potential losses with gains from the short bond CFD, depending on market movement. This can offset or make up for price drop in their bond holdings.

Note that as hedging is a risk-management tactic, it only works when bond prices are falling.

News-Based Trading

News-based trading is a trading strategy that relies on relevant news reports for trading ideas. The idea is to track and anticipate important news that affect the bond markets and make a trade based on the likely direction the market will follow as a result of the announcement.

Generally speaking, news may be categorised into unexpected news (terrorist attack, natural disaster, unforeseen economic or financial event) and recurring or anticipated news (inflation rate reports, employment figures, monetary policy announcements). Some examples of tradeable news are:

• US Federal meetings
• GDP growth forecasts
• Corporate earnings reports
• Geopolitical tensions or hostilities
• Oil price hikes
• Election results

Given the bond market’s sensitivity to geopolitical and macroeconomic factors, news-based trading may present opportunities for bond CFD traders during periods of increased volatility. This is due to the likelihood of heightened volatility immediately after a news announcement, or the period leading up to it; as such, news traders often focus on trading during important news cycles.

Range Trading

A range trading strategy revolves around buying and selling a bond CFD as the price moves within a predefined range. The key here is to correctly identify the floor and the ceiling that a bond market moves within–but not beyond–over a period of time.

Range trading works best with relatively calm bond markets that do not typically have wild price swings over the targeted trading period. Once such a bond market has been identified, a range trader may open a long position when the price nears previously established support levels, and hold it open until the price approaches resistance, at which point the position is closed.

When the price falls back down to support, a new long position is opened, and the cycle is repeated. Range trading can pay off well if the bond market continues to trade between a strongly established range.

Trend Following

In trading, a trend following strategy focuses on identifying a prevailing price trend, and then aligning your trade accordingly. This means that if an uptrend is identified, a trader may go long; if a downtrend is seen, a trader may go short.

The position is held open until a trend reversal is imminent; at which point the position is closed. When a new price trend has been established, a new position may be opened to align with the observed trend.

Trend following may appear straightforward, but it can be challenging to identify trends in real-time. Traders should be cautious and disciplined in setting exit strategies, as market conditions can change rapidly.

Setting Stop Loss Orders

Stop loss orders are instructions for your broker to close your position when a certain price level is reached or exceeded. You can set a stop loss as you set up your trade, and once set, the order will trigger automatically.

This is an important tool in risk management, as it helps traders to exit a losing trade while limiting losses. However, stop loss orders are not foolproof. If a serious event causes the market to drop far beyond the stop loss point, losses can be greater than expected.

Nonetheless, bond CFD traders should learn to set stop loss orders at appropriate price levels. This will not only help to keep losses manageable, it will also instil discipline and head off the temptation to keep trades open longer than you should.

In particular, stop loss orders are useful when volatility is expected, such as when interest rate hikes are announced, geopolitical tension escalates, or when economic outlook worsens.

Controlling Leverage Due to Interest Rate Volatility

As explained earlier, central bank interest rates are a major driver of bond market price action. Unexpected interest rate changes can cause sudden price changes; this can pose a serious challenge when trading bond CFDs using leverage.

Leverage allows you to open a trade at a fraction of the cost of the full trade value. This provides several advantages, including greater capital efficiency, smaller initial capital, and the ability to control a larger position (or multiple ones) with limited funds.

Importantly, leverage also amplifies your trading outcomes–both profits and losses–as your results are calculated based on the full value of the position, not the initial deposit.

Additionally, when using leverage, your account must maintain sufficient margin to keep your position open. This margin can increase significantly during interest rate volatility, causing your broker to put out a margin call.

When faced with one, traders have to top-up additional funds to keep their position open. Failing to do so will cause your position to be closed and losses assigned to your account.

Therefore, it is vital that traders control the use of leverage so as to reduce the risk of being wiped out in a margin call during inflation rate volatility. Consider reducing your leverage when trading bond CFDs when inflation rate announcements are expected, especially if you have insufficient trading funds to meet margin calls.