Investing > Fixed-Income Trading Explained

Fixed-Income Trading Explained

Want to trade, but worried about the risk? Fixed-income trading could be just what you're looking for. 

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Updated January 20, 2022

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Want to go for a swim in the securities market without getting too wet?

This is actually possible, thanks to something known as fixed-income trading. ✅

Simply put, this involves trading fixed-income assets which specify an amount of income they will deliver to you over the course of a period of time. Before you get too excited, however, know that these assets typically don’t feature high returns—and trading them can be tricky. ⚠

Because fixed income investments generally don’t offer a high return, they also tend to be less risky, especially during a time of market uncertainty, as they are considered “safe” investments. This proved to be true following the COVID19 pandemic when many investors moved investments back to fixed-income assets in order to lower their exposure to risk in case of a market decline due to high inflation.

Whether or not you are worried about the market declining, it may be worthwhile for you to look into fixed income trading, as it is viewed by some investors as a great way to manage risk while also getting in on some trading action. Keep reading to learn all about fixed income trading and how you can use it to your advantage.

What you’ll learn
  • What is Fixed Income Trading?
  • Tradable Fixed-Income Assets
  • What Affects Fixed-Income Security Prices?
  • How to Trade Fixed-Income Securities
  • Trading Fixed-Income vs. Trading Stocks
  • Advantages and Limitations
  • Conclusion
  • Get Started with a Stock Broker

What is Fixed-Income Trading? 📚

Fixed income trading is exchanging fixed-income securities on an over-the-counter basis. Fixed income investments are securities that return a specified amount of money to the holder of the investment over a period of time. Although you may never have heard of them, there is a wide selection of fixed-income assets available to trade. 

Everyone in this world needs money, including banks, companies, and governments, which is why these fixed-income assets exist. 

For example, buying bonds is an example of buying fixed-income securities. In this case, you are loaning your money to a company in exchange for interest payments over a period of time. This means an investment in a bond will not only return to you the initial price of the bond after a period of time, but it will also give you interest payments as you wait for it to come to maturity. 

Although trading fixed income securities is generally considered low risk, they are not no-risk, as it is always possible a company could default on the bond. 

How a bond works
A bond’s risk level and interest rate highly depend on the creditworthiness of its issuer.

You also need to consider that trading fixed income securities does not generate as much of a revenue stream as trading stocks may. This is because you need a lot of money to join the fixed income trading market, and you need to be knowledgeable about the inner workings of inflation and government policy in order to be successful.

This is one of the reasons why fixed income trading is generally more of a long-term trading strategy and is usually dominated by corporate investors. 

However, just because fixed income securities can be long-term trading investments and provide lower returns doesn’t mean there isn’t a reason to trade them, as some fixed income securities can bring you nice trading profits. 

Fixed-Income Assets You Can Trade 🗃

Want to dive into fixed-income trading? You’ll need to know a little more about the types of assets you can trade first.

Bonds are the most popular fixed-income asset, but they certainly aren’t the only one. When it comes to investing in fixed-income trading, the asset you choose to trade will depend on your trading style as well as your investment goals.

Treasury Bills 📜

One of the safest types of fixed-income securities is a treasury bill, this is because a treasury bill is a bond or debt security that is issued by the U.S. government. Since the government can control the money supply, which includes printing more money at will, it is extremely unlikely that the government will default on a treasury bill. 

The unique thing about treasury bills is that they are issued for a variety of fixed periods. This gives you many options as an investor as to how many years you want to loan the U.S. government your money. 

housing market crash of 2008
By comparing the TLT Treasury bond ETF to the S&P 500, we can see that bond prices go up in times of crisis—they move oppositely to stocks. Image by TradingView.

While treasury bonds typically aren’t very volatile, the average yearly return is just 1.45%—not much considering you’re letting the government use your money for a long period of time.  

Bank Fixed Deposits (Certificates of Deposit) 📃

Fixed bank deposits or CD’s are very similar to treasury bills in that you are placing an investment in the bank you are depositing your money into, and you will be paid interest for doing so. Unlike treasury bills, you cannot cash out at any time.

Although fixed bank deposits are seen as being just as safe as treasury bills, it is possible for them to go under, so there is a slight risk to this type of investment. These investments are preferred by those who want to protect their money but are unlikely to need it soon—since you cannot cash out at will. 

The problem with CD’s? You won’t make much money. Although the interest rate does vary by bank, most of them are less than 1%, meaning you are better off giving your money to the U.S. government via a treasury bill above. 

Corporate Bonds 💰

Don’t want to invest in the government or a bank? Corporate bonds are the same thing, but a long-term investment in a corporation. These are higher risk than bank or government bonds as a company is much more likely to go under. 

The reason many investors idolize corporate bonds is because there are many companies to choose from that are seeking investment, and therefore it is possible to find companies which are undervalued. One the other hand, you can also run across very risky, high-yielding bonds popularly called junk bonds. 

HGY corporate bond ETF
If we look at the HGY corporate bond ETF, we can see that company bonds also suffer during stock market crashes. Image by TradingView.

Corporate bonds vary in yield depending on the company you are investing in. But it is possible to get a return in the neighborhood of 3% annually from a corporate bond. Some go as high as 6%, while others will be as low as 1%. 

Fixed-Income Mutual Funds 💵

This type of fixed-income security is a combination of fixed-income assets that has been put together by a broker to garnish the holders of shares of the fund a return. Many large brokers like Vanguard have fixed-income mutual funds and they are typically considered a good investment for people during retirement. 

Most of these funds focus on trying to return the highest amount of money possible to investors. For example, one fund by Vanguard specifically focuses on investing in junk bonds and returns about 4.3% to investors each year

Asset-Backed Securities 💸

Asset backed securities are securities which are backed by a physical asset such as a mortgage (homes) or car loans. Next to treasury bills, asset-backed securities are very famous because they made a name for themselves by playing a key role in the financial crisis caused by the real estate crash in 2008

These fixed income securities can be very risky. This is because investment bankers can design these in numerous different ways. They are the ideal investment for someone who wants a fixed income security but enjoys taking lots of risk.

If these are so risky, you may be wondering why people invest in them (or trade them). And the reason is because they can return 8% or more to investors. When compared to the yield of the other assets on this list you can see how they would be very attractive to a potential investor. 

What’s Affecting Fixed-Income Security Prices? 🤔

Ready to start trading some fixed income assets? Then you’ll need to know how to do it, and the first thing we want to know when we’re trading something is how we can sell it for more money than we bought it for.

Generally, most of the top stock trading platforms will have a section on their platform where you can purchase and sell fixed income securities. Some banks may offer this service as well—but, before buying anything, you should do some research. 

Because fixed-income securities aren’t the same as stocks, you’ll find that the metrics which affect stock prices are not the same ones which affect bond prices. Below are some examples of the types of things which will affect the prices of fixed-income securities. 

Default Risk ✅

The number one aspect which dictates the price of a fixed income security is the likelihood that the issuer will default on the loan you are giving them. And the securities with the highest risk (the lowest credit score) will bring in the highest returns.

This means that if you see a fixed income security that has a high yield, you’ll probably want to look a little closer at that security, as it is highly possible that the company issuing the bond will be unable to repay. Government bonds, which carry little to no risk, typically offer very little return. 

Interest Rate Risk ✅

Some fixed-income securities, such as those issued by the government and banks, are at a high risk of their interest rate changing. This risk rate is factored into the price. The higher the risk of the interest rate changing in the future, the greater the yield of the bond. 

Price Change Risk ✅

Because investors are typically planning to hold on to fixed-income investments for a long period of time, the probability that the price of the security will change in the future needs to be taken into account. 

This won’t affect all investors, but those who think they may want to cash out of the investment early need to be aware of this risk, as they may end up cashing out for lower than the price of the security. This is something you will want to pay attention to if you are planning to trade fixed-income securities. 

Inflation ✅

This brings up the next metric you need to be worried about. Because of the long term nature of fixed-income investments, you also have to look at inflation, as this will affect the real rate of return of the bond. The real rate of return is the actual rate of return of the bond adjusted for the current inflation. 

Fixed-income securities are highly susceptible to risk, and there is a chance you could garnish a negative return if inflation gets too bad. This happened to many investors after the COVID19 pandemic when the U.S. government announced the rate of inflation was officially above 6%, meaning any fixed-income security with a yield of less than 6% practically has a negative yield. 

How to Trade Fixed-Income Securities 💡

Fixed-income securities are often approached as long-term investments, but if you’d rather not have these sitting in your portfolio (they aren’t going to add much anyway), they can be traded. 

Trading fixed income securities doesn’t mean you need to buy them one day and sell the next. Moving fixed-income securities in and out of your portfolio is considered trading as long as the securities enter and leave your portfolio in the same year. 

There are two main tactics when it comes to trading fixed income securities. 

Tactic 1: Trade the News 📰

As mentioned above, fixed-income securities are highly susceptible to inflation and government-controlled interest rates. This means a good way to trade fixed income securities is by watching the news, and  when they report on these events, tailor your trades based on what they report

If you get really good, you can even try to predict the news. For example, when the government announces that a change in interest rate is coming, you can guess whether they’re going ro raise or lower interest rates. If the government has been dovish lately, they will probably not raise rates, so you can bet on this and make your trade. 

Tactic 2: Bet on Longer-Term Trends 📆

If you’d rather not watch the news every day and be ready for instantaneous trades, you might want to consider betting on longer-term trades. For example, if the real estate market is currently experiencing a surge, it might be a good time to get into an asset backed security with real estate as the asset. 

Of course you have to be pretty sure this trend will continue. And if for some reason, at any point, you think it won’t, you need to prepare to make a sporadic trade to exit your position. Betting on long-term trends is a very common tactic when there is a bear market which investors think will continue. 

Trading Fixed-Income vs. Trading Stocks ⚖

Because fixed-income securities don’t return as much money as stocks, you may be wondering if there is any reason to trade bonds over stocks. Well, you’ll be surprised to find out that there are actually several benefits to trading fixed income securities. 

The Market is Huge 🎯

The first benefit of trading fixed-income assets is the size of the market—it is simply massive! Numerous companies are looking to get money via bonds, and unlike stocks, you can sometimes predict how a bond will perform based solely on the company’s financial reports. 

In the 3rd quarter of 2021, SIFMA estimated that the size of the fixed income security market in the U.S. was $51.8 trillion. Compared to the NYSE, which was “only” worth $26 trillion, the fixed-income market is huge, but the major stock markets roughly have a 50% larger trading volume.

It’s Simpler to Navigate 🔍

When you are shopping for stocks, you need to evaluate a company from several different aspects. You can’t measure how a stock will do on just on a single metric. Bonds, on the other hand, you can evaluate much more quickly and easily, typically just by looking at the default risk. 

Less Volatile 📊

The fixed-income securities market is dominated by corporations which makes it much less volatile than the stock market. Corporations are much more rational when it comes to investments when compared to individual investors, which means there will be many less market ups and downs due to trading psychology in the fixed-income securities market. 

Bonds-vs-Stocks
Bondholders have a priority over stock owners in the case of a company defaulting—they are more likely to get their money back. 

But this doesn’t mean that there aren’t benefits to trading stocks as well. One problem with bonds is that they don’t have as much up-to-date information about how your money is doing. Rather, you kind of have to sit around and wait to see what happens to inflation and the interest rates to see if holding your bond is worth it or if you should trade it for something else. 

Not to mention that some fixed-income securities are illiquid, meaning you can’t cash out whenever you want, rather you have to wait the full term of the investment. This can make them a challenging investment to trade as you will be unable to take advantage of changes in the market when you need to. 

Advantages and Limitations of Trading Fixed-Income Securities 👨‍🏫

Now that you know the benefits of trading fixed-income securities, it’s time to discuss some of the additional advantages they have over other types of investments as well as some of the limitations they face. 

Advantages of Fixed-Income Securities 🌟

The main advantage of trading fixed-income securities is that you are better able to control the level of risk you are exposed to. Rather than choosing a stock, doing some research, and hoping for the best, the probability a company will default on the money you are loaning it is posted when you purchase the bond. 

These securities also are much more forgiving. If you purchase a bond, and later decide it was not the bond you wanted to purchase (or maybe the interest rate isn’t what you wanted) holding the bond until a better opportunity comes along isn’t a problem. Sure, you aren’t making the money you wanted, but it won’t crash to 0 either. 

Another possible advantage is the way bond purchases are priced by a stock broker. Traditionally, instead of charging a trade fee, the stock broker simply marks up the price of the bond. Sometimes this is a better deal than performing daily trades where you will need to pay a fee each time. This is something to look into if you are serious about trading fixed-income securities. 

Limitations of Fixed-Income Securities 🚧

Sounding a little bit too good to be true? Well, there are several limitations to trading fixed-income securities. 

The obvious limitation is that it is very difficult to earn a high rate of return on bonds. This is because many of them have yields under 5%. Higher ones do exist, but they typically come with more risk. Therefore your bonds are definitely not your get rich quick scheme and are really only worth investing in if you have a lot of money to invest (i.e large corporations).

Plus, as previously mentioned, some fixed-income securities cannot be cashed out until the end of the term. This means you may be stuck with a poor bond investment for the long term. 

Pros

  • You can control the level of risk you are exposed to.
  • The risk is visible at the beginning of a trade.
  • Forgiving
  • Possibly less trading fees.

Cons

  • Difficult to get a high rate of return
  • Sometimes there are limits on when you can trade a security.
  • Require a high initial investment

Fixed-income securities simply aren’t suggested for traders who need to be moving capital around frequently to gather a big enough return. It also takes quite a bit of capital to get started with some of the assets in fixed-income securities, meaning many newer traders are simply priced out of trading these assets. 

💡 Curious how fixed income compares to other asset classes? Learn about fixed-income vs. equity.

Conclusion 💬

Overall, if you want to start trading the stock market, but are scared of the levels of risk you may encounter along the way, then the fixed-income security market may be for you. You may not make as much cash, but at least you know your money isn’t likely to evaporate as you learn the trading ropes either.

Before trading fixed-income securities, it’s important to evaluate the company you will put your money in just as you would if you were buying stock. But luckily, with fixed income securities this is an easier and less stressful process, meaning someone who is just beginning to dip their toes in the world of trading may just have a little fun along the way. 

Fixed-Income Trading: FAQs

  • Can Fixed Income Securities Lose Money?

    Although fixed income securities are generally considered to be safe investments, there are some cases in which they can lose money–such as in the financial crisis of 2008. Also, in periods of high inflation, assets such as bonds tend to offer returns that are outpaced by the rate of inflation, which means they effectively lose money over time.

  • Who Trades Fixed-Income Securities?

    Most traders of fixed-income securities are corporations because they have a lot of money to invest over the long term, but anyone who wants to trade fixed-income securities can with an account with a stock broker. 

  • How Much Money Do You Need to Trade Bonds?

    If you are interested in trading bonds, it is recommended that you have an initial investment amount of $100,000, as many bonds only return a fraction of a percentage in interest. 

  • Is Trading Bonds Good for Beginners?

    Trading bonds is good for a beginning trader because it is hard to mess up, but at the same time they can be difficult for beginners because they can require a large initial deposit. 

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