Party With The Fed: Explore Ways to Trade Interest Rates

Let's do free association with the word bond. What ideas come to mind? For starters, slow, low returns, and complicated. And the bond market (aka “fixed income”) is where the Fed and central banks meet giant financial institutions, like investment banks and insurance companies, to argue weighty matters like interest rates, inflation, and money supply. Ugh. Too scary for us little folk, right? Wrong. There’s no reason to be intimidated by the Fed. If you’re savvy, you can play the bond market in several ways that are trader-friendly—like futures, ETFs, as well as certain stocks. And, if you are an options trader, you can employ some of your favorite options strategies.

When it comes to trading interest rates, you have lots of choices beyond simply buying bonds outright. So, rather than be scared of the Fed, you can likely find a place in the bond market that suits your trading and investment objectives.

TREASURY BONDS
THE BEAUTY OF SEESAWS

First things first. You need to understand how bond prices change relative to changes in interest rates. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up. Bond prices and interest rates are inversely related. Commit this to memory.

A bond is like a loan. When you buy a U.S. Treasury bond, you’re loaning the U.S. Treasury money for a period of time specified by the bond’s maturity date. Like any loan, you expect your principal or loan amount to be paid back, and to receive interest that represents the return on your investment from that loan.

Say you buy a $1,000 Treasury bond at the market price that pays 5% interest yearly and matures in 30 years. In 30 years, you’ll get your $1,000 for the value of the bond, and every year you will have been paid $50 in interest. Fast-forward six months. You buy a second $1,000 Treasury bond that pays 6% annual interest for 30 years. Now, you have two bonds—one that pays 5% interest, and one that pays 6% interest. All things being equal, you’d rather have the bond paying the higher interest because the bond that pays 5% is less desirable. When interest rates went up from 5% to 6% in those six months, the value of that bond paying 5% went down. So if you went to sell that bond now, you would likely get less for it than you paid.

Now, in reality, what moves bond prices can be the expectation of future interest rates rising and falling. That’s why the price of Treasury bonds can move so much in response to Fed announcements. The Fed makes a comment about quantitative easing or inflation, and the market expects interest rates to rally. Accordingly, bond prices will fall. Bond prices can also change when the ability of a bond’s issuer (i.e., a country, a state, a city, a country, or a corporation) to make interest payments or even pay the principal back becomes stronger or weaker. In the third quarter of 2014, the market value of Greek bonds dropped sharply when the world thought Greece couldn’t pay interest on its bonds. The “quality rating,” which refers to the issuer’s ability to meet its interest obligations, or some other protections built into the bond, of Greek bonds went down, and so did their prices.

BOND FUTURES
TRADERS SPOUTING OFF

Now, on to the bonds themselves. While you can trade all sorts of municipal, corporate, and government non-Treasury bonds, traders generally trade Treasuries—specifically, 30-year bonds and 10-year notes. And, while you can buy a physical bond or note from  the U.S. Treasury, many traders use futures on those Treasuries to express bullish or bearish opinions on the bond market. For instance, /ZB (the 30-year Treasury bond future) and /ZN (the 10-year Treasury note future), along with their options, are generally quite liquid with tight bid/ask spreads. Their prices also tend to respond directly to interest rate changes. When the Fed makes an announcement, or there’s some important economic news, it’s often /ZB and /ZN that react first. Traders buy and sell them because they can typically execute those trades quickly—much faster than if they had to buy the actual Treasury bond.

Of course, /ZB and /ZN are futures contracts. And you need a futures account to trade them, along with their options. Going a step further, /ZB and /ZN are also big contracts. A one-point price change is worth $1,000. That’s 10x bigger than a one point move in 100 shares of stock. These contracts are also highly leveraged. The margin required to buy or short one /ZB future is about $4,400. But the value of the /ZB contract at the time of this writing is $160,000. Profits and losses can grow quickly with /ZB and /ZN futures. It may be possible to use options on /ZB and /ZN to create defined-risk spread positions that have lower margin requirements.

Quick note: if you look at /ZB and /ZN quotes, you’ll see expirations for the futures in March, June, September, and December. Those are not the maturity dates of the underlying Treasury bonds. They are the expiration dates of the futures contracts, by which time physical Treasury bonds and notes can be delivered against the futures.

But what’s the difference between /ZB for a 30-year Treasury future, and /ZN the 10-year Treasury future? For one thing, 20 years between maturities. That makes /ZB and the 30-year Treasury bond more sensitive to changes in interest rates than /ZN and the 10-year note. This concept is called “duration,” which describes a bond price’s sensitivity to interest rate changes. Other things being equal, bonds with longer maturity dates have more duration, and their prices will change more when interest rates fluctuate.

EXCHANGE-TRADED FUNDS
BONDS CLOSER THAN YOU THINK

If you’re looking to trade the bond market but prefer equities instead of futures contracts, and still have actively traded options, consider ETFs—exchange-traded funds—in the bond space. They typically don’t have a principal guarantee like a Treasury bond, but may be bought and sold like a stock in an equity account. No futures account required.

A few bond ETFs have single points between strikes, meaning option strategies like vertical spreads and iron condors can be created with lower capital requirements. And each point between bond-ETF strikes represents only $100, not $1,000, as is the case for /ZB and /ZN options. (Bear in mind the ETF is different than actual cash, so it will mirror but not be exactly the same.) For smaller accounts, or for investors who like to keep risk lower than futures, bond ETFs can be a another choice for trading the bond market, if you understand the differences between ETFs, futures, and Treasury bonds themselves.

STOCKS
INTEREST RATE OPPORTUNITIES ABOUND

To take the bond market a step further, some like bank stocks, which can be interest-rate sensitive. Banks, as you know hold a lot of money. And they make money by lending out that money. With higher interest rates, bank stocks can rally because they can earn more on the money they lend. If the broader market crashes, it could take banks down with them, regardless of what interests rates do. On the other hand, stocks that typically pay high dividend yields, like utilities, can tend to drop when interest rates rise as investors choose higher-yielding bonds. Housing stocks, too, can tend to drop when interest rates rise, as it becomes more expensive to borrow money to buy homes.

Sure, the Fed can surprise us at any moment. But choosing the right bond, or interest-rate-sensitive product, combined with a trading strategy aligned with your risk tolerance, means you can position your portfolio to better handle those surprises.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.