Buy and Hold versus TradingNovember 26th, 2011 by David Waring
For fixed income investing, “Buy & Hold” and “Trading” refer to two different investment approaches.
The Trading Approach
Active buying and selling of investment products such as bonds, according to changes in prices. The basic principle is to buy low and sell high, where possible.
The Buy & Hold approach
Says you can do better than using the trading approach, and avoid both unnecessary risk and transaction costs by holding your bonds to maturity.
Active Trading and Transaction Costs
It’s tempting to think that by actively trading bonds you could cherry-pick the most profitable opportunities, and optimize your portfolio. The biggest problem with this line of thought, and what kills the profits of most active traders, are the transaction costs involved with active trading. You incur two different costs when buying and selling a bond:
When you trade bonds as an individual you do so through a bond broker. That broker charges you a commission for giving you access to the market and you pay that commission both when you buy the bond and when you sell it.
When you place a bond trade through your broker, that broker sends your trade to a bond dealer to be executed. Bond dealers make money by charging a spread, which is the difference between the price where you can buy a bond and the price where you can sell it. All traded securities have a spread. On most stocks,the spreads are less than a few cents per share. Not very significant unless you are buying or selling every day. However, many bonds can have spreads which approach 1/2% which means that the bond has to go up more than that amount for you to make a profit if you sell.
The commission and spread which you pay when trading a bond are going to vary widely depending on the type of broker you are trading with, the type of bond you are trading, and the liquidity of the market for that bond. The bottom line is the more you trade the higher your costs are, and the higher your return has to be in order to just break even.
Additional Risks Associated With Active Trading
If you are an active trader then by definition you are not holding a bond to maturity. This brings about two additional factors which have to be considered:
When you buy a bond and hold it to maturity, you know exactly how much money you are going to make and when that money is coming to you. If you buy a bond and sell it before maturity that certainty goes out the window. As interest rates change over time so do the price of bonds. Bonds which are sold before their maturity date can therefore lose or gain substantial value, exposing the investor to additional uncertainty and potential for loss.
Many types of bonds are not actively traded in the secondary market. This means that when you go to sell a bond before its maturity date, there may not be a willing buyer. In this situation you will be forced to accept a price for the bond that is substantially below its fair value. Liquidity risk is particularly high when selling municipal bonds. On the other hand, liquidity risk is not generally a concern when trading US Treasuries.
Buy & Hold to accentuate the positive
A buy and hold approach significantly reduces transaction costs, market and liquidity risks. In particular, you know from the start the dollar amount you will receive at maturity and that the issuer is obligated to buy it back and the end of its term. When a bond investment matures, you can look for a new bond opportunity with higher interest rates. You can also use a laddering strategy to make several bond investments with different maturity dates, and renew each one to take advantage of positive changes between times, while still holding the bond to maturity each time. This puts the buy and hold investor a large step ahead of the active trader, right from the start.
For more information on how to buy and sell individual bonds go here.