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Tata Capital > Blog > Wealth Services > Important Aspects You Need to Know Before Trading in Bonds in the Secondary Market

Wealth Services

Important Aspects You Need to Know Before Trading in Bonds in the Secondary Market

Important Aspects You Need to Know Before Trading in Bonds in the Secondary Market

Investing in bonds can be a great way to generate a steady income stream and diversify your portfolio. However, trading in the bond market is complicated and not as simple as buying stocks.

Before entering the secondary market, you must know the critical aspects that could impact your investment and returns. From understanding interest rate trends to evaluating credit ratings and maturities, there's a lot to consider.

Here’s what you must know before trading in bonds in the secondary market-

#1 Secured or Unsecured

Secured bonds are backed by assets owned by the issuer. In case of default, the assets are sold to repay the bondholders. This is an important aspect that the buyer needs to check.

#2 Analyse interest rate trends

The bond market has an inverse correlation between a bond's price and interest rate. If the interest rate is high, the bond's price will be low, making it an opportune time to buy. Conversely, if the interest rate is low, the bond's price will be high, making it a good time to sell.

Therefore, carefully analyse the interest rate trends before buying or selling bonds in the secondary market.

#3 Focus on yield and not coupon bond

Don't fall into the trap of high coupon rates when considering purchasing bonds. A bond's coupon is the annual interest rate paid on the bond. It is shown as a percentage of its face value. However, when looking at bonds in the secondary market, it's essential to pay attention to the bond's yield, which is the return you'll receive.

For example, a bond with a 12% coupon rate may only provide a 10% return if its price has increased since its issuance. In contrast, a bond with a 10% coupon rate may offer a 12% return if its price has dropped since its issuance.

So, when buying a bond from the secondary market, consider its price and yield.

#4 Ascertain the bond's maturity date

Bonds have different maturity periods. For instance, short-term bonds have maturities of one to five years and long-term bonds have maturities exceeding 12 years.

But why consider the bond's maturity? To evaluate interest rate risk. It is the potential increase or decrease in a bond's price with changes in interest rates. The longer a bond's maturity, the more likely its value may be affected by fluctuating interest rates before it matures. This results in a lower bond price.

Therefore, before you start trading, make sure your investment goals align with the bond's maturity and potential returns.

#5 Review the bonds ratings

When investing in bonds, it's important to check ratings from top rating firms, like CRISIL, ICRA, and CARE. This will help you avoid taking credit risk and can prevent investment from default risk.

The AAA bonds are typically the safest, with a very low chance of default. However, they also tend to generate lower yields compared to lower-rated bonds. While some investors may opt for lower-rated bonds for higher yields, it can be a risky strategy.

#6 Check Liquidity

If you don’t intend to hold the bond till maturity, then you need to have enough exit options on the table. Check overall liquidity of the bond in the market before getting into the deal.

#7 Callability

Some bonds have call option with it, which means issuer can buy back bonds on that particular date before maturity. In falling interest rate cycle where coupon is considerably higher than the prevailing interest rate then issuers may buy back bonds. Therefore, you need to check this feature as well if you are planning long term investments with such high yield bonds.

Wrapping up

Bond trading can be tricky. And ignoring these critical aspects could cause significant financial losses. So, before you get started, ensure you have a well-thought-out strategy and a deep understanding of the market dynamics. Remember, in the bond market, the stakes are high, and a wrong move can cost you dearly.

If you seek expert guidance to make well-informed investment decisions and diversify your portfolio, turn to Tata Capital Wealth.

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