From the January 01, 2012 issue of Futures Magazine • Subscribe!

How to understand and trade the bond market

Why trade bonds?

Given bond characteristics, there are a number of reasons they may be attractive for active traders. Depending on what is important, the bond markets offer liquidity, portfolio diversification and even attractive trading hours.

The U.S. Treasury futures market is one of the most active and liquid markets in the world (see "A deep well," below). "The Treasury market is gigantic. It’s extremely liquid; it’s a great place to hide. It’s an easy place to buy into or get out of because bid-ask spreads are very narrow," Baily says.

In addition to providing liquidity, bonds traditionally have provided a more conservative type of investment than equities (see "Moving apart," below). "Treasuries tend to have a negative correlation to the equity market. So, if the equity market becomes very fearful, Treasuries will tend to rally," King says. "That’s a place to hedge or diversify your risks from a portfolio perspective."

Be careful, though, because this inverse relationship is not as reliable as say, gold and the dollar.

Bonds often rally on bad economic news and sell off on good news. A poor Gross Domestic Product (GDP) or employment report may lead the Federal Reserve to lower interest rates, leading to higher bond prices. Positive GDP and jobs reports or an inflationary Consumer Price Index report may indicate inflation will rise, causing the Fed to raise rates and push bond prices lower.

Finally, the bond trading hours are attractive for two reasons. First, the bond pits are open when most of those major reports come out and second, it’s fairly easy to determine the most active trading times of the day.

"One of the nice features of bond trading is that the bond market is open when almost every report hits," says Jack Broz, founder of TradeBondFutures.com.

This is important because the bond market is a measure of interest rates, which are determined by economic conditions, so economic reports, especially those that measure the economy and inflation, drive the market. Broz recommends waiting for the markets to digest news first. "There’s a huge list of reports. But, as a bond trader, you’re not going to try and predict reports, or compete with the Goldmans and Citigroups by guessing what the number will be and how it’ll move the markets, because that’s not going to work," he says. "It’s like being in a minefield. If you get yourself flat and then react to the report, more times than not you can figure out where it wants to go from there."

Because of the nature of the market, bond activity typically is easy to track throughout the day. "You have certain periods of that day that are more active than other parts of the day," says Earl Spencer, trading manager of treasuries and securities at HTG Capital Partners. "You come in in the morning and the market will trade reasonably actively until basically 10:30 in the morning, which is when Europe closes. Then you hit a stagnant patch and [then it gets more active] around 1:30-2:00 p.m."

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