So You Wanna Be a Bond Trader?

Updated on March 12, 2007.

IN GENERAL, we believe investors should look to the stock market for capital appreciation, not the bond market. But there are times when the outlook for the bond market is particularly bright: If interest rates seem to be cresting and the economy slowing, then that would probably be a good time to make a speculative investment in bonds. For instance, 2001-03 were extremely profitable years to buy bonds since their values rose as interest rates fell. For a glimpse of the current state of interest rates, check out the Living Yield Curve.

Of course, if you feel uncomfortable taking interest-rate risks with bonds, you should follow only a buy-and-hold strategy. But if you're willing to make a call on interest rates, you might as well focus on those choices that give you the biggest bang for the buck. Keep in mind, if you expect interest rates to rise, buying long-term bonds is not going to pay off. If bonds are paying 5% this year and 6% two years from now, in the future your 5% bonds will look paltry and you'll have a harder time selling them for a profit.

What makes all of this so tricky is that the sweet spot changes with your own goals as well as with the market. Bond performance in 2006 was particularly confusing because of the "inverted yield curve," which means that the yields on long-term treasuries were slightly below those with shorter durations. This happens when bond investors are worried about significant weakening in the U.S. economy. Generally speaking, 2006 wasn't a bang-up up year for most bond investors.

Here's a look at how various types of bonds respond to changing interest rates:

The opportunity for profits during the right interest-rate environment is substantial. Consider this example. Say you paid $3,427 for a 20-year government zero with a 5.5% yield and a maturity value of $10,000. If over the course of the next year long-term interest rates were to fall by one percentage point, the bond's market value would increase by 20%.

Of course, interest rates can work against you, too. A one-percentage-point rise in rates over a year would hammer the bond's value by about 18%. Bottom line? Long-term zeros are for investors who are convinced interest rates are falling or for investors who intend to hold the bonds until they mature, thus making any price fluctuation meaningless.

Another way to make zero plays is through American Century's Target Maturities funds (800-345-2021). This fund company offers four no-load portfolios, each with a minimum initial investment of $2,500, that aim to match as closely as possible the return of individual zeros maturing in the years 2010, 2015, 2020 and 2025. You can even construct your own ladder of speculative zeros at minimal cost.

Clearly this takes a lot of research — but if you're right, the upside could be substantial. As the issuer's circumstances improve, so too will its credit quality. And that in turn means the price of the bonds (which you probably bought at a tidy discount) should rise. Beginning investors could benefit from the expertise of fund managers when it comes to choosing bonds, executing trades and managing call risk (i.e., reinvesting the proceeds if a company calls its bonds).