Home Trading strategies 5 Bond Trading Strategies – (Video, Backtest, Example, Performance, Setup, and Rules)

5 Bond Trading Strategies – (Video, Backtest, Example, Performance, Setup, and Rules)

Despite being much larger than the stock market, the bond market gets much less attention from short-term individual traders. That’s a shame because bonds are great trading vehicles. This article will explore bonds and show you examples of how you can trade them. Why would you trade bond trading strategies?

Bond trading strategies are a great inclusion in a portfolio of strategies because they offer diversification and, most likely, uncorrelated returns. Bonds are complementary.

This article examines Treasury bonds and shows you several backtested bond trading strategies. We don’t examine corporate bonds (which are mainly traded in the over-the-counter market) but Treasury bonds.

What is a bond?

A company or sovereign state that issues a bond (the borrower) gets money from investors (the lender). Investors provide capital to the borrower in exchange for a promise from the issuer to pay interest on a fixed schedule for a certain period of time and to pay back the principal when the bond matures.

Let’s give an example:

You might want to invest one million in a ten-year bond paying 3% semiannually. That means you get 15 000 every six months until the bond matures, and you get back the outstanding one million (hopefully).

But investing in bonds involves risk, and you need to overcome the following three risks:

  • Credit Risk: The borrower (issuer) might get into financial trouble during the ten years and fail to honor the semiannual payments and might not return the one million.
  • Interest Rate Risk: If you need to raise money or sell the bond prior to maturity, the price of the bond might change. If rates are higher now than when you invested, the bond’s price is lower (and vice versa).
  • Inflation Risk: Even if you hold the bond until maturity, you might “lose” due to lost purchasing power.

Bond trading example

Let’s show you how the price of a bond varies.

Three years back, you invested one million into ten-year Treasuries with a paltry 0.5% semiannual yield which pays 2 500 every 6 months.

However, the stock market has crashed in the meantime, and you want to sell the bonds to invest in stocks. Stocks are cheap.

But unfortunately, interest rates have risen, and no buyers are willing to pay what you paid for them. As a matter of fact, not only stocks have crashed, but also bonds because interest rates have increased. Because of the increased rates, bond prices need to go down. Today the bid is at 80 for your bonds. Thus, your one million investment is only worth 800 000. Quite a loss! This is interest rate risk, and it’s for real.

We hope you get the point on why bond prices fluctuate.

Is bond trading profitable?

That depends on the strategy, of course. But as you’ll discover in this article, the main benefit of bond trading strategies is that they are complementary and add to the overall returns.

Why bond trading strategies are good

Bonds are volatile, but the best part is that bonds usually don’t correlate too much with stocks. They are complementary.

The chart below shows the 25-day rolling correlation between SPY and TLT (red line). The black line is the 200-day moving average. SPY tracks S&P 500, while TLT tracks Treasury 20-year bonds.

As you can see, the correlation goes up and down, but the black line is around zero most of the time, indicating no correlation (the blue line marks zero):

Bond trading strategies correlation

If you want a primer on correlation, please see our separate article:

Bond trading strategies backtests

We assume you are most interested in specific bond trading strategies.

Let’s look at some specific bond trading strategies. The strategies below are backtested on the ETF that tracks 20-year Treasury bonds (TLT), but they can most likely be traded by using the corresponding futures contract, given you use the same official trading hours as TLT.

Bond trading strategy backtest 1

Our first bond trading strategy was published a few years ago and called Calendar Effects In Long-Term Treasuries.

The trading rules are simple (this is a seasonal strategy):

  • Buy at the close of the seventh last trading day of the month.
  • Sell at the close of the last trading day of the month.
  • Sell short at the close of the month.
  • Cover at the close of the seventh trading day of the month.

The strategy has returned the following equity curve:

Bond trading strategies - seasonal trading

The trading statistics and metrics are good:

Bond trading strategies historical performance

The return is more than twice buy and hold despite being invested just 61.8% of the time. If we look at the risk-adjusted return it’s even better at 16.58%.

We argue these are “spectacular” returns for such a “simple” strategy! We believe seasonal patterns are one of the lowest-hanging fruits in trading.

Bond trading strategy backtest 2

Our second bond trading strategy is the monthly trading edge from June 2021. It trades TLT and has three variables to decide when to buy and a straightforward exit criterium.

Bond trading strategies - trading rules

The performance metrics and statistics are good:

  • No. of trades: 265
  • Average gain per trade: 0.38% (0.96% for winners and -1.16% for losers)
  • Win ratio: 73%
  • Profit factor: 2.1
  • CAGR: 4.9%
  • Exposure/time in the market: 15%
  • Max. drawdown: -9%

Bond trading strategy backtest 3

We have more bond strategies; the next one is also in TLT and was our monthly trading edge for our subscribers in December 2022.

It’s a seasonal strategy that trades from the short side. It has two variables: seasonal and intermarket (we use another market/asset as input):

Bond trading strategies - historical performance
  • No. of trades: 192
  • Average gain per trade: 0.57% (1.9% for winners and -1.7% for losers)
  • Win ratio: 63%
  • Profit factor: 1.9
  • CAGR: 5.1% (assuming no leverage)
  • Exposure/time in the market: 25%
  • Max. drawdown: -13%

Bond trading strategy backtest 4

The following strategy is also a long swing trade in TLT and was our monthly trading edge for March 2023. It has one price action variable and one based on a seasonal effect.

It has the following equity curve:

Bond trading strategies - statistics

The historical performance is good and we get the following trading statistics:

  • No. of trades: 227
  • Average unleveraged gain per trade: 0.44% (1.0% for winners and -1.09% for losers)
  • Win ratio: 73%
  • Profit factor: 2.4
  • CAGR: 4.8% (assuming no leverage)
  • Exposure/time in the market: 13%
  • Max. drawdown: -8%

Bond trading strategy backtest 5: combing with S&P 500

One of the main reasons for why including bonds are diversification. They are complementary.

To show you how we’ll combine our TLT strategies with one of our strategy bundles for S&P 500.

Let’s start by showing the backtest results of our beginner strategy bundle in S&P 500, which trades SPY or the futures contract (ES):

Bond trading strategies example

The results are very good and uncorrelated to the overall market return (buy and hold). The average gain per trade is 0.7%, and the annual unleveraged return is 11.5% – significantly better than buy and hold despite being invested just 23% of the time.

But what happens if we include bond strategies 3 and 4 mentioned above? The result improves a lot:

Bond trading strategies - combining with stocks

The annual returns increase from 11.5% to 19.2% while drawdowns decrease. This is precisely why we want to add complementary strategies, and this shows that bond strategies add valuable diversification. Drawdowns decrease even though we spent more time in the market (50%) after we added the bond trading strategies.

Bond trading strategies – conclusion

This article has shown how to improve your trading by adding complementary bond trading strategies. If you want to take your trading to a higher level, you are likely better off by adding strategies that might not be “perfect” on their own but work nicely together with other strategies.

You are not looking for the perfect strategy but strategies that complement each other.

Previous articleThe Worst-Performing Stocks – Negative Returns Since JFK Was President (60 years!)
Next articleDecoding the Post-Holiday Effect in Stocks