Buying Bonds - Selling Bonds - Trading Bonds

The basic relationship between the price of a bond and prevailing market interest rates is an inverse relationship. For example, if you have a 5% bond (this means that it pays $50 annually per $1000 of face value) and interest rates jump to 7%, wouldn't you agree that your bond should be worth less now if you were to sell it?

If the rate of interest being paid on newly issued bonds stands at 7%, a bond buyer would get paid $70 annually for each $1,000 investment in one of those bonds. If that bond buyer instead bought your old 5% bond for the price you originally paid, that bond would yield $20 less per year when compared to bonds on the market. Clearly that's not a very attractive offer for the bond buyer. This basic premise explains why bonds decline in value when interest rate rise.

Investors buy bonds to provide a fixed return on their investment. A bond buyer has a very good idea what his nominal return will be. The real risk is what the real return will be. Let’s say a retiree has $1,000,000 they want to live off for the next 10 years. The bond will pay him $50,000 per year (interest paid every six months.) If interest rates rise, the value of the bonds will decline but the payments will stay the same. The real risk to bond holders is a decline in purchasing power due to inflation. If the annual inflation rate for the 10 years he holds his bond is 5 percent, the $50,000 he receives that last year would be worth $25,000.

If you expect inflation, why would you hold bonds? Why not sell them short and buy them back after the prices have declined? Certainly bondholders that lived through the inflationary 70’s wish they had done exactly that. So how does short selling work. The trading firm borrows the bond (or note) from a broker, then sells the instrument and holds the proceeds in a margin account. When the price of the bond declines, the firm buys the bond back and returns them to the broker. The profit is the difference between the price at which they sold and then bought back (minus carrying costs.) Carrying costs are the interest owed on the bond and the amount borrowed to facilitate the transaction. The amount of margin that is required by the trading firm can vary depending on the credit worthiness of the customer. Obviously the more leverage employed the greater the return (and risk.)

Example of a short trade:

1. You sell short a 10 yr Note at 97. Based on the present level of interest rates your note is 97% of face value (i.e. $100,000 X .97=$97,000.)
2. Interest rates rise and the price of your note drops to 95 (.95 X $100,000 = $95,000.)
3. You buy back the Note at $95,000 and pay carrying costs of $315.22 (interest due + margin) for a net gain of $1,684.78.

An Investor's Guide to U.S. Treasury Securities is a pdf file that clearly explains the full range of securities issued by the U.S. government. The guide shows investors the role of treasuries in their portfolio; the different products offered by the U.S. Treasury including notes, bonds, inflation-indexed securities, strips and savings bonds; information on market risk; and yield and price information. It also includes a section on how to read the newspaper to determine prices and yields and has a complete glossary of terms for easy reference.