Understand the Quality of Bond Credit

• Bond prices will be impaired even if the bond is currently making timely interest payments if investors perceive the ability to pay principal and interest, called debt service, might decline in the future. Bond traders must know the precise terms of the bond agreements, called covenants, and what remedies are available to investors if bond covenants are impaired. Anticipating broad economic changes among different types of industry sectors, countries, and technologies will have different effects on different bonds. Bond trading requires special knowledge of bankruptcy law if trading distressed, or junk securities.
  
  

Create a Spread Trade

• Bond traders make substantial profits by trading large amounts of bonds, referred to by their par amount, or redemption value. This is necessary because bond prices move very little on any particular day as interest rates trend intermittently over time. However, use large bond positions to create positive carry, the spread between the bond's daily earned coupon income and the trader's cost of borrowing to hold a bond position. If the cost of carry becomes negative bond traders hold smaller positions and try to avoid holding bonds overnight. This results in greater volatility, or variance in bond prices.
  
  

Call Features

• Bond trading requires strict attention to call features. Call features give bond issuers the right but not the responsibility to redeem bonds early if they so choose. This is often done to eliminate high interest costs by refinancing debt when interest rates decline or to remove bond covenants, or promises in the original bond agreement, that prove to be restrictive. Bonds that move in price above par no longer participate fully in price appreciation since they are priced to the short maturity call. This has substantial effects on the bond's liquidity. Bond trading requires, in market rallies, that discount bonds, bonds priced below par, be purchased in order to avoid early redemption calls and obtain the full price appreciation of any rally.
  
  

Bond Arbitrage

• The single most important bond trading rule is to reduce risk wherever possible. Bond arbitrage allows traders to hedge or reduce risk by shorting one bond while buying another in expectation that the price relationship of the two bonds is changing. Shorting is the selling of a security in expectation of a decline in price. Yield curve, the plotting daily of closing bond prices over a period of time is an example of arbitrage. Arbitrage should be arranged to allow positive carry. This will offset the costs of failed trades.