Beginner's Guide to Trading Fixed Income: Part 2 - Process for trading fixed-income securities

In this section, we’ll take a closer look at the process for evaluating and trading fixed income securities, starting with an analysis of how an investor can screen the fixed-income universe to select an appropriate security or securities. We’ll then move on to discuss how an investor can determine what a fair price might be for the security he or she has chosen to purchase. (For related reading, see: How to Create a Modern Fixed-Income Portfolio.)

Screening the fixed-income universe

One of the primary challenges investors face in the fixed-income market is deciding which issue to focus on from among the many available options. Screening the universe is necessary to narrow your focus. The starting point for any screen should be your needs. First of all, you should consider what role within a portfolio the security you are considering will fill. Are you searching for safety, capital appreciation, tax advantages or income? (See also: Advanced Bond Concepts.)

A full discussion of the specific securities that might meet each of these primary needs is beyond the scope of this article, but briefly:

• Safety. If you're interested primarily in safety, it’s best to focus on the highest quality securities to avoid credit risk – and on shorter maturity securities to minimize interest rate risk. Potential securities might include U.S. Treasury and agency securities; CDs and other money market instruments; and perhaps short-term corporate debt or municipal bonds issued by the highest quality corporations and municipalities. Most of the issues you focus on should have maturities less than five years, and perhaps even under one year, depending on your needs. (See also: Corporate Bonds: An Introduction to Credit Risk.)
• Capital appreciation. If you’re are seeking capital gains, you’re likely to focus on lower-rated securities, such as high-yield bonds or emerging market debt. You might also consider longer-maturity corporate or government bonds if you believe interest rates are likely to fall. (For more, see: An Introduction to Emerging Market Bonds.)
• Tax advantages. If you're in a high tax bracket and seeking to maximize your after-tax income, you’ll likely narrow your focus to tax-free municipal bonds most of the time. It still pays to consider other forms of fixed-income, however, and to compare the after-tax yield on both taxable and tax-free securities. (See also: How are Municipal Bonds Taxed?)
• Income. Many fixed-income investors seek income in their portfolios, and nearly all fixed-income securities will provide at least some income for investors (there are exceptions, such as zero-coupon bonds). Depending on how much risk you’re comfortable with, you might narrow your focus towards corporate bonds or mortgage-backed securities if income is your primary goal. (For more, see: Introduction to Asset-Backed and Mortgage-Backed Securities.)

Once you have identified what role the bond you are seeking will play in your portfolio, you have substantially narrowed your investable universe. The next step in your fixed-income screen should be to decide on a broad set of characteristics. For instance, what maturity range do you want your bond to fall into? This could be as broad as knowing that you want a bond in the 10- to 15-year range, or as specific as seeking a bond that matures in July of 2020. Seeking a bond that matures at a particular point in time is a common practice for investors who know that they need their money back for a future cash flow need. (See also: 7 Questions to Consider Before Investing in Bonds.)

Another characteristic to isolate is the bond rating you're looking for. Although the ratings supplied by the various bond rating agencies are far from perfect, they do provide a useful starting point for credit analysis. In general, higher-rated securities tend to be safer than lower-rated securities. Other important characteristics that might help you narrow your search are whether you want a bond that is callable or noncallable, and in the case of corporate bonds, whether there is a particular industry you are seeking. Note that diversification pays in the bond market as well as the stock market, and if you're building a portfolio of corporate bonds, you should try to diversify across industries. (For related reading, see: Callable Bonds: Leading a Double Life.)

Narrowing the search

Once you determine the characteristics of the security you're seeking, you can narrow your search even further. If you have access to a Bloomberg terminal or another trading platform, you can pull up all the securities outstanding from specific issuers and then narrow your focus to the ones that best suit your needs. If you decide that income is your primary investment goal, that taxes are not a consideration, that you want a bond with a 7- to 10-year maturity and an investment-grade rating, and you want a company in the banking industry – you might wind up focusing on several issuers.

In this hypothetical example, the issuers you come up with might be Citigroup, JPMorgan Chase, Bank of America, Morgan Stanley, Wells Fargo and Goldman Sachs. Let's say you already own a Citigroup bond, a Bank of America bond, a Morgan Stanley bond and a Wells Fargo bond, and for whatever reason you're not interested in owning Goldman Sachs bonds. In that example, you have now narrowed your focus down to bonds issued by JPMorgan Chase. You can then use your trading platform (or Bloomberg terminal) to list all of JPMorgan Chase’s outstanding corporate bonds, focusing on those with maturities in the 7- to 10-year age. You can then choose a particular issue based upon valuation, issue size or availability, and then go out and purchase it in the marketplace. (See also: How to Analyze Corporate Bonds with Bloomberg Terminals.)

There are three potential flaws with this method for selecting a particular security. The first is that not everyone has access to a Bloomberg terminal or similar system. The second is that even after performing the process described, there may still be a number of bonds that meet all your criteria, and you may not have the inclination or ability to choose a particular bond. The third problem is that even after you have identified a particular bond, you still need to go out and buy it – and there's no guarantee that you’ll be able to find the bond you have focused upon at a reasonable price.

After having screened the universe down to a manageable size through the process listed above, you can then contact (either online or over the phone) the bond department of the brokerage firm you use to see what bonds they have in inventory. You can compare this inventory against your chosen criteria, thereby coming up with a shortlist of available issues that both meet your fixed income screening criteria and are available for purchase. At that point, you can choose whichever issue seems most attractive on a valuation basis and buy it for your portfolio. (See also: Dodd-Frank Creates a Liquidity Crunch for Bonds.)

Determining a fair price for a fixed-income security

While the current market price for a stock is easily attained, finding the "fair" value for a particular bond at a given moment can be more difficult. There are two main ways to determine a fair price for a bond. The first is to see where it has been trading in the market, and the second is to calculate a fair value based upon its characteristics.

The easiest way to determine a fair price is to see where the bond has traded recently. The Financial Industry Regulatory Authority (FINRA) requires broker-dealers to report trade prices shortly after execution for many types of bonds, through what is known as the TRACE system. These trade prices are publicly available. If you have access to Bloomberg, and are using the system to analyze bonds, you can find this TRACE data alongside the rest of the bond's characteristics. If you don’t have access to Bloomberg, you can still access TRACE data through the FINRA website. (See also: Where Can I Get Bond Market Quotes.)

Looking at recent prices will give you not only an idea of what level the bond should trade at, but also what the trend in price activity has been. It’s important to keep in mind that if you're only interested in trading a small position of a bond, your pricing may be somewhat worse than what you see in the TRACE data. That’s because the best pricing in the bond market generally goes for executions of greater than $1 million, while smaller pieces are often penalized.

Looking at recent trade prices is a great start, but just as in the stock market, bond market trading may not accurately reflect what the "true" intrinsic value should be. Depending on market conditions, recent trades could be much higher or lower than where a bond's value actually is. Furthermore, some bonds don’t trade very frequently, and if that’s the case for the bond that you are seeking to buy or sell, there may not be any recent trades that have been reported to TRACE.

Under these circumstances, you might wish to calculate what you believe the fair value for a bond to be. There are a couple of ways to do this. Most bonds trade on a spread basis, because investors wish to receive additional compensation for taking risk beyond that which is inherent in Treasury securities (spread refers to the additional yield of a bond above that of a comparable Treasury security). Therefore, one way of valuing a bond would be to determine how much additional compensation you believe would be fair for the additional risk you are taking relative to a Treasury. (For more, see: Bond Spreads.)

In general, the greater the risk you are taking, the greater the additional compensation you should get. This means you should receive more spread for buying a high-yield bond than a very high-quality investment grade bond. Similarly, you should receive more spread for buying a less liquid issue than for a very large and liquid issue – and you should receive more spread for purchasing longer maturity securities than one with a shorter maturity. (See also: Do Long-Term Bonds Have a Greater Interest Rate Risk than Short-Term Bonds?)

The final method for calculating what your target price for a trade should be is to look for levels at which comparable bonds have traded. For instance, you might decide that Intel and IBM have reasonably similar credit profiles and should therefore trade at reasonably comparable prices. If you cannot find recent trade data on the Intel bond that you're trying to purchase, you could instead see where a comparable IBM bond has traded, and use that as a rough approximation for what the value of the Intel bond should be. (For more, see: Tech Companies Have Raised Record Debt from Bond Markets This Year.)