If you are interested in entering the world of investment you may have heard of the term Bond CFD and wondered what exactly it refers to. A Bond CFD is a financial instrument that brokerage firms offer to their customers.
The acronym “CFD” stands for “Contract for Difference”, meaning that the instrument’s capital return reflects the difference between the reference bond’s opening and closing prices. When trading in these, there isn’t any physical bond delivered, and the difference is settled in cash.
There are two ways in which the reference bond is tied to the Bond CFDs, the first being the buy versus sell reference bond price difference, and the second being the coupons being paid by the reference bond. The brokerage firm offers these terms, holding the bond directly to hedge its position so that coupons the bond pays to the broker are able to be fractionalized, then paid to holders of the Bond CFDs.
If you are now asking what all this means to you, here are some of the reasons the exciting world of Bond CFDs may be of interest to you:
Higher Yields and Higher Leverage – the differences between buying bonds directly and purchasing Bond CFDs. For investors interested in the use of leverage to invest, Bond CFDs margin requirements range to a low of 20%, making it very attractive. So, with only a $20k cash investment you can purchase $100k worth of notional Bond CFDs.
Compare that to the higher margin requirements of purchasing direct bonds, in particular the typically unrated SGD bonds. While there are occasionally direct bond purchases with 20% margin requirements, these are generally limited to large issue size investment grade bonds.
It is possible to accrue relatively high yields thanks to the built-in leverage of Bond CFDs, quite often with high single to double-digit percentage leveraged yields. Say that you purchased a $50,000 notional of an at par Bond CFD that requires a cash margin of 20%, equivalent to $10,000 to be put up by you.
Considering that there is an annual coupon rate of 5% attached to the reference bond, a 2% per annum financing cost, and over the course of the year the reference bond’s price remains constant, then the return after one year would be $1,500 from your initial cash investment of $10,000, which means a 15% leveraged yield. Losses or gains are amplified, which could be a negative or a positive to the investor.
It’s a good idea to allocate spare savings for any resulting account top-ups or emergency use so you will be prepared if things go the wrong way.
Buying Bonds Directly vs Bond CFDs – $250k or US$200k are the minimum denominations the majority of corporate bonds trade with for direct purchases. Ideally, at least 20 to 30 bonds comprise a diversified bond portfolio, translating to a $5m to S$7.5m portfolio size. Even larger portfolio sizes might be better for investors interested in dealing directly with new bonds issued at attractive prices.
Compare that with the much more accessible amounts beginning at $50k that Bond CFDs trade in. An investor might be able to achieve a 20-30 bond diversified bond portfolio with a Bond CFD exposure of only S$1m to S$1.5m if Bond CFDs were used. Much greater diversification is possible thanks to the Bond CFD’s low minimum denominations. The smaller minimum trade size also applies to investors participating in new bond issues from CFDs.
It is important to note that the trade size of the bond is what is referred to by the minimum denominations above. The required cash in the account differs from the margin requirement of the trade size. Circumstances may arise in which the investor may need to top up the margin requirement’s cash thanks to the fluctuation of the bond prices, so it is always a good idea to maintain spare cash well above the minimum in the event of that happening.
A Forex Spread is not necessary – The currency in use for margin requirements can be different from that in which the CFDs are denominated in, a boon to the investor. The cost of FX spreads isn’t incurred by the investor because Bond CFD purchases do not require any actual FX conversion. In the investor’s trading account spot FX rates are needed to compute updated margin requirements, but this doesn’t require any FX conversion.
Suppose that the investor buys US$50k of a Bond CFD with a (Singapore Dollar) S$50k cash margin in the Bond CFD account available. Assuming a 1.35 USD/SGD FX rate, the required trade margin would amount to S$13.5k. Since conversion to USD is not required, the investor can deduct the S$13.5k from the available S$50k margin.
Investors can thus do their transactions without a Forex spread because no Forex conversion is required. For those who wish to use other currencies like the EURO, Australian Dollar, and Japanese Yen, for the purchase of Singapore and US Dollar Bond CFDs, paying for Forex spread isn’t necessary for the cash margin requirements.
Buying Bonds Directly vs Bond CFDs – The three main advantages of Bond CFDs are the lack of Forex conversion, lower minimum investments, and the possibility of higher yields on the investment. Conversely, there are some possible disadvantages that include some counterpart risk in regard to the broker’s solvency, the possibility of higher interest payments, and the fact that there are no voting rights for Bond CFD holders.
Are Bond CFDs really profitable? – The answer to that question is definitely a yes, but there are certain risks involved when compared to other trading venues. The best Bond CFD traders are those who have already accrued a few years of trading experience, veterans with tactical acumen well practised in strategy.
The many advantages of Bond CFD trading are that global markets are easily accessible, there are no rules in place for day trading and shorting, very few or even no fees, and margin requirements that are much lower.
In closing, Bond CFDs are an excellent opportunity if you are able to absorb the risks attendant. We hope this has helped your investment plans, and wish you good fortune with all your trades!
