Bonds in practice - charts, ups, downs, differences

CFA Level I Fixed Income
#1

Hi,

After reading fixed-income session, I saw some news and charts regarding the market and I am wondering whether I understand the things well. I have few questions regarding the bonds in practice. Also I will write some things, in which I can be mistaken, so I would appreciate if someone would correct my mistakes. Some things might be out of the scope of the Level 1 exam. I put the numbers next to the question to make the answers easier (if anyone answers me obviously :slight_smile: ).

All the things I am going to write will be about sovereign bonds. Mostly, because I do not see any public charts of concrete corporate bonds. I just see indices or ETFs for this type of bonds. (1) Is it caused by the lack of liquidity in the market or some other limitations? Does anyone invests in corporate/non-sovereign/quasi-sovereign/supranational bonds using charts and technical analysis?

The increase of the bond’s yield can be caused by:

  • demand and supply levels

It works like demand-supply rule for every normal good: if there is an excess demand the price goes up, if there is an excess supply the price goes down. The price is inversely correlated with the yield, thus yield goes down in the former case and up in the latter one.

  • interest rates

They are positively correlated with bond’s yield. This is the rate, which central banks pay for reserve to commercial banks. It automatically declines the value of bond’s yield. (2) Why? Does it work directly (the decline in interest rate is also a decline for interest rate on government bond market) or indirectly (there are cheaper substitutes than sovereign bonds, so government bond’s yield must go down in price too)?

  • inflation

Higher inflation makes yield rise. In inflationary environment people require higher return and also the government can have higher return from borrowed money, which it is going to give back later.

  • economic growth prospects

In the bullish market people invest in other securities than sovereign bonds. Therefore the demand falls down and yields go up. However here I am in doubt with one thing. Generally low inflation or deflation is associated with recession. Then yields are on the low levels. (3) Does not lower inflation level during economic downturns offset economic growth effect and in consequence make the price stay on the same level?

  • risk of default

I read on some websites that sovereign bonds are not really risk-free bonds and it is not only about countries such as Greece, Italy, Spain or Portugal during the crisis, but also about countries which seem to be in a good situation.

Ok, so now I am coming to the main part of my post with the most important questions.

Above you can see the daily chart (taken from TradingView) for 2-year US-Treasury Note. (4) How is the data for the chart counted? From on-the-run bonds? Or secondary market? Or something with more complexity? The bond yield has risen by almost 100% since July! (5) Is it caused just by the same reason as why stocks are rising? I do not know where, I think that in CFAI Curriculum, I read somewhere that fixed-income markets are not correlated with equity markets…

In the picture above you can see the bond yields for different maturities (source CNBC). Longer maturity - higher yield (maturity premium). (6) Why do the yields for different maturities behave differently? Ok, the general pattern is the same, but it is not the first time when I see that for example the bond with 5 year maturity rises and the one with 30 year maturity fall downs.

I know it is a long text, but I would really be grateful for the answer :slight_smile: Maybe also someone else would find it interesting and useful :slight_smile:

#2

Hi,

I’ll try to answer some of your questions.

  1. Corporate bond yields may differ by issuer, rating, industry etc. There is no uniform chart for corporate bonds since the credit spread (vs. government bonds with similar maturity) is composed of default risk, liquidity risk, and potentially other non-financial risks as well.

  2. It is not as if interest rates are some separate variable that determine the yield on bonds, it is market-determined and often influenced by a nation’s central bank as part of monetary policy. When we talk about interest rates we usually mean the yield on risk-free bonds such as government bonds issued by AAA countries such as U.S. Treasuries. In relation to your answer, I would say it’s the latter. Bond yields can be broken down into many different components, such as the expected inflation rate. If investors expect the inflation rate to rise in the U.S. due to expectations of increasing economic growth, one would expect it to affect all U.S. bonds evenly (be it govvies or corporates). If not, arbitrageurs would jump in on the opportunity and sell bonds that did not go down in price (due to rising inflation -> rising interest rates -> decreasing bond prices), and buy bonds that did go down in price with similar cash flow patterns, earnings a (near) riskless profit.

  3. Not sure about what you mean? In a recession real interest rates and (expected) inflation typically fall resulting in a decrease in nominal interest rates. I don’t see any offsetting effects occurring.

  4. Bonds are primarily traded in dealer markets, dealers quote their bid/ask spreads (at what price/yield they are willing to buy/sell). The chart you posted shows quoted yields based on the quotes posted by dealers in the market (secondary market).

  5. Look up the risk factors/return components of stocks and bonds. Every asset class can be decomposed into different return components that are driven by different risk factors. Simply stated, bonds are primarily driven by interest rate and credit risk, stocks by equity risk (further decomposed in business risk, financial risk etc.).

  6. Supply and demand, short-term vs. long-term expectations, monetary policy. For supply and demand, take the Euro swapcurve, it has been in an inverse state (past 20yr maturities) for years primarily due to financial institutions such as pension funds wanting to hedge their interest rate risk with long duration instruments to match their long-term liabilities (future pension cash flows are discounted at swaprates). Expectations are reflected in the yield curve, short-term expectations on the shorter end, long-term expectations on the longer end of the curve. Monetary policy via setting the discount rate (short-term lending rate for banks) and open market operations are usually conducted at shorter maturities.