Tuesday, February 8, 2011

BOND TRADING 101

by BondSquawk

 

How Bond Prices Fluctuate


A bond’s market price, like the price of any financial asset, represents the present value of the stream of future cash flows to the bondholder.

A dollar in your hand today is worth more than a dollar that you receive a year from now due to several factors:

You can deposit that money at a bank

Purchase an investment that will yield you a return for the next year.  The present value is discounted by the rate of return you could earn on that dollar over the next year (the discount rate).  Our example represents a one-time future payment, but the concept is the same for bonds that represent a stream of future payments.  The discount rate for a bond is its yield.

The price of a bond is a function of the coupon of the bond relative to the market yield of equivalent bonds.  For example, a bond with a coupon rate of 5% will be priced at par if the market yield is also 5%, if the market yield is below 5%, the bond will trade at a premium, and if the market yield is above 5% the bond will trade at a discount.  Since bond prices fluctuate with changes in market yields or the general level of interest rates, in order to determine the factors that influence bond prices we need to understand what factors influence the general level of interest rates.

 

What Determines the Level of Interest Rates?

Because treasuries have no default risk, they represent the risk-free rate of return (though treasury bonds are subject to other risks such as interest rate and reinvestment risk).  Treasury yields have three components:
  1. The risk-free real yield
  2. The inflation premium that reflects the expected rate of inflation
  3. The volatility premium that represents the risk associated with the price sensitivity of longer maturity bonds to changes in interest rates
Non-treasury bonds have a fourth component, the credit risk premium, which we will cover in another lesson.   Because treasury TIPS are indexed to inflation, their yield gives an indication of the risk-free yield.

There are a few factors that affect the price of treasuries including supply and demand, general economic activity, and budget and trade surpluses or deficits.  However, the single most important factor is the general level of interest rates, and the general level of interest rates is mainly determined by the expected level of inflation.

It is obvious that if one was able to have a reliable indication of future changes in interest rates, then one could make considerable profits in the bond markets.  Fortunately, there are some very good ways to get an indication of where interest rates are going, and we will discuss these rate indicators in future lessons.

 

What Influences the Level of Credit Spreads?

All domestic bonds that are not treasury issues contain some amount of default or credit risk.  This risk means that these bonds must compensate the bondholder for assuming this risk by providing a yield greater than what a treasury security of the same maturity would pay.  This yield premium is known as the credit spread.  For example, if the 10-year treasury note is yielding 5% and a 10-year AAA rated corporate bond yields 5.75%, the credit spread is .75%.

The credit spread represents the market’s perceived creditworthiness of the bond issuer and will not only vary from one bond to another, but will fluctuate over time for the same bond.  The credit spread is calculated based on the current on-the-run treasury.

The primary determinant of a bond’s credit spread is the bond’s credit rating.  However, not all bonds of the same credit rating and maturity will trade with the same credit spread.  Factors that can cause an issue’s credit spread to be larger/smaller than the credit spread of other issues of the same credit rating include:
  • A negative/positive outlook for the issuer’s industry group
  • A competitive disadvantage/advantage for the issuer
  • Expectations of a ratings downgrade/upgrade
  • A deteriorating/improving business or financial trend for an industry or issuer
  • An issue with less/more relative liquidity

 

The Yield Curve

A yield curve is a graph of the yields of closely related bonds of different maturities. The vertical axis of the graph represents the yield, and the horizontal axis represents the time to maturity. The yield curve of treasury securities is the most commonly seen yield curve in the U.S.

 

There are four basic yield curve shapes:

“Yield Curves” The Upward Sloping Curve

“Yield Curves” The Inverted Yield Curve

“Yield Curves” The Humped Yield Curve

“Yield Curves” The Flat Yield Curve


The upward sloping curve is historically the norm given the normal relationship that the longer the time to maturity, the higher the yield.  An inverted yield curve occurs when interest rates are very high and expected to fall.  A flat yield curve indicates that the term to maturity has no impact on interest rates, and a humped yield curve initially rises, but then falls for longer maturities.  Inverted and flat yield curves are fairly rare.  In recent years institutional investors have had high demand for the 30-year long bond, which has raised its price to the point that it often yields less than the 20-year.  This has caused the humped curve to be the most common shape in recent years.

The shape of the yield curve changes with the business cycle and has been a good leading indicator of economic activity.  A steeply positive sloped yield curve is indicative of an economic recovery, and is often found at the end of recessions.  Its shape reflects market expectations of a significant increase in interest rates and the fact that the fed is keeping short-term rates low to aid a slumping economy recover.

Inverted curves often precede an economic downturn.  The Fed has been raising short-term rates to slow down the economy because of high inflation and the market is anticipating that interest rates will fall, so long-term rates are lower than the extremely high short-term rates.  Inverted curves have proceeded all of the last 7 recessions (although not all inverted curves have been followed by a recession).

A flat yield curve is often the result of the Fed raising short-term rates to cool an overheated economy.  Flat yield curves are rare and do not last very long when they appear.

Many bond traders use the shape of the yield curve to derive trading strategies.  Future lessons will delve into analyzing the yield curve and yield curve related trading strategies.

 

Repurchase Agreements (Repos) and Reverses

Repo, short for repurchase agreement (also known as RP), is a form of short-term borrowing for government securities dealers.

In a repo transaction, the dealer sells a treasury security to investors with an agreement to repurchase the security at a later date, usually the next day, and at a fixed rate of return to the investor (the repo rate).
Repos can also be done for a longer term, such as a week or a month (this is known as term repo) or a Repo can be done on open without a fixed repurchase rate.

The rate for an open repo is most often renegotiated on a daily basis.  It is effectively a short-term loan that is collateralized by a treasury security.  The investor (lender) in the transaction is entering into a reverse repurchase agreement or reverse.

Typically, the term repo is used for both repos and reverses since the terms only refer to which side of the transaction one is on.

Dealers use repos to finance their activities because treasury securities are subject to market risk (because the price fluctuates). Due to the changing price, the investor will not lend the full value of the security.  The difference between the value of the security and the amount that is borrowed is called a haircut.

 

The Carry Trade

The principal behind the carry trade is to borrow short to purchase a longer-term bond that will pay a higher rate than the rate of the short-term loan.

Dealers finance their treasury purchases by borrowing against their treasury holdings by doing repo transactions, which are essentially loans collateralized by treasuries.
The risk/reward is determined by the spread between the treasury yield and the repo rate the dealer pays.
Longer maturity bonds will trade at a greater spread because:
  • They are more price-sensitive to changes in interest rates
  • They have a longer time horizon that presents more uncertainty as to the level of interest rates.
If the Fed raises rates – a dealer could end up with a negative spread.
The two-year note is a particularly popular security for the carry trade because its yield is closely tied to the fed funds rate and it is extremely liquid.

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