How to trade bonds

When interest rates rise, bonds become less desirable, and their prices drop. If you think this is set to happen, you’d adopt a ‘short’ position on one of our government bonds futures.

When going short, you elect to ‘sell’ a derivative to open your trade. To close your trade, you’d ‘buy’ the derivative back. You’d earn a profit if you sold for a higher amount than you bought at, and cut a loss if the reverse were true.

However, please note that short selling is a high risk trading method because bond prices can keep rising – theoretically without limit. This means that when taking a short position, you stand to incur unlimited losses. You can attach stops to your positions to protect yourself by capping your loss.

Taking a short position on a government bond can be a way to hedge against possible downturns in the real income earned from shares and bonds you already own.

Inflation is an increase in the aggregate price level as measured by changes to a price index, like the CPI. When inflation is high, the dividends paid by shares and the fixed coupons paid by bonds both lose value in real terms – ie they have lower purchasing power.

This, in turn, negatively affects each asset’s market demand and price. By shorting the bond market and potentially profiting from the decrease in bond prices, you could lessen some of your real income losses.

But, hedging incurs significant risk. This risk is only amplified when trading with leveraged derivatives like CFDs as you stand to lose more than the margin amount you deposited to open a position. Additionally, when short-selling, your losses could be unlimited if the market moves against you and bond prices keep rising.

Interest rate risk is the possibility of rising interest rates causing the value of an investment to fall. Fixed-income assets like bonds are exposed to this type of risk. If you hold bonds or shares in a bond ETF and expect to cut a loss owing to a hike in interest rates, you could hedge by going short on the government bonds futures market.

For example, if you think the Bank of Japan is going to increase interest rates, you could open a position on the bonds futures market by electing to ‘sell’ a derivative like a CFD. If your prediction is correct and bond prices fall, your profit on the trade would mitigate the loss to your other investments.