clarification on some bond basics
I am new to studying bond markets, and I'm having trouble understanding
what traders expect based on Fed actions. If anyone here could answer my
questions or correct my thinking below, I would appreciate it. Write as
much as you want, I will read it.
from BondSquawk "Bond School" section:
http://www.bondsquawk.com/bond-school/bond-trading-201-how-to-trade...
"A flattening curve means the spreads between short-term
treasuries and long-term treasuries are narrowing. In this
environment, traders will buy longer term treasuries, and short shorter
term treasuries."
q1: why buy long term if short term gives same yield but less
commitment? *expected* price increase/decrease in long/short term
bonds?
conversely:
"When the Fed lowers the fed funds
rate, the yield curve tends to steepen, and traders will tend to buy the
short end and short the long end of the curve. A steep positively
sloped curve results from the Fed maintaining low short-term rates, but
investors are expecting rates to rise."
q2: if rates are lowered, wouldn't bond price increase? are traders
buying in *expectation* of these bond price increases, after the
increase (doesn't makes sense why one would buy after price already went
up), or something else is going on?
from:
http://www.suite101.com/article.cfm/fixed_income_bonds/54791/2
"When the market expects the Fed to lower the fed-funds rate, short-term
maturities tend to outperform long-term maturities because short-term
interest rates fall faster than long-term rates. When the Fed is raising
interest rates, shorter maturities rise faster in yield (mostly because
financial institutions fear negative carry situations and because
investors feel that they can delay their purchases of short-term
securities and get a higher interest rate on their investments if they
wait). In this case shorter maturities underperform long-term
maturities."
q3: "When the market expects the Fed to lower the fed-funds rate", the
prices of short-term maturities go up, it is the price that outperforms
the longer-term maturities? This is difficult for me to follow because i
would consider "outperforming" to mean the bond had higher yield, not
higher price. So, if the Fed is expected to raise interest rates, the
short-term rates rise faster than long-term because they're tied
more-closely to Fed Funds rate? Since the short-term rates rise, their
prices fall, and they "under-perform" the long-term bonds?
what traders expect based on Fed actions. If anyone here could answer my
questions or correct my thinking below, I would appreciate it. Write as
much as you want, I will read it.
from BondSquawk "Bond School" section:
http://www.bondsquawk.com/bond-school/bond-trading-201-how-to-trade...
"A flattening curve means the spreads between short-term
treasuries and long-term treasuries are narrowing. In this
environment, traders will buy longer term treasuries, and short shorter
term treasuries."
q1: why buy long term if short term gives same yield but less
commitment? *expected* price increase/decrease in long/short term
bonds?
conversely:
"When the Fed lowers the fed funds
rate, the yield curve tends to steepen, and traders will tend to buy the
short end and short the long end of the curve. A steep positively
sloped curve results from the Fed maintaining low short-term rates, but
investors are expecting rates to rise."
q2: if rates are lowered, wouldn't bond price increase? are traders
buying in *expectation* of these bond price increases, after the
increase (doesn't makes sense why one would buy after price already went
up), or something else is going on?
from:
http://www.suite101.com/article.cfm/fixed_income_bonds/54791/2
"When the market expects the Fed to lower the fed-funds rate, short-term
maturities tend to outperform long-term maturities because short-term
interest rates fall faster than long-term rates. When the Fed is raising
interest rates, shorter maturities rise faster in yield (mostly because
financial institutions fear negative carry situations and because
investors feel that they can delay their purchases of short-term
securities and get a higher interest rate on their investments if they
wait). In this case shorter maturities underperform long-term
maturities."
q3: "When the market expects the Fed to lower the fed-funds rate", the
prices of short-term maturities go up, it is the price that outperforms
the longer-term maturities? This is difficult for me to follow because i
would consider "outperforming" to mean the bond had higher yield, not
higher price. So, if the Fed is expected to raise interest rates, the
short-term rates rise faster than long-term because they're tied
more-closely to Fed Funds rate? Since the short-term rates rise, their
prices fall, and they "under-perform" the long-term bonds?
Views: 17
Replies to This Discussion
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Permalink Reply by Maulik Mody on -
Hi Ray,
I will try to address your questions one by one, just as you have posted them.
a1. here the trader sees a steep curve in the market and has a view that the curve might flatten. A steep curve means that interest rates in the longer end are higher than he expects them to be, ie, bonds are cheaper since investors demand higher yields.
In this case, he will put on what is called a flattener trade where he buys in the long end of the curve (which is steep right now, so rates in long end are high, so price is low) and sells in the front end (which is at a lower yield, so higher price as per his expectations). All this is keeping in mind that he expects the curve to flatten, so yields in the longer end will fall (price of the bonds he bought will rise) and/or yields in the short end will rise (bonds he shorter will fall in price).
I don’t know what exactly you mean when you say "why buy long term if short term gives same yield but less commitment?" The long-term and the short-term will provide different yields right, hence the upward (or downward) facing curve and not a straight flat line.
a2. What that statement meant was, when the Fed decreases short-term rates, the yield curve tends to steepen. But it does not steepen immediately, but traders expect it to eventually. So they buy in the short term, (assuming it will steepen, yields will fall, prices will rise) and sell in the long term (where yields will rise, prices will fall). In general, even though the steepening might be caused by just the long end going up (which the trader has shorted), traders take both long and short positions in the short and long end of the curve respectively for the reasons described in the article.
a3. I am not sure what exactly the writer meant, but one of the reasons might be what you said. The short term rates are closely tied to Fed Fund rates, while long term rates are tied to expectations. What is written is not necessarily always true. For example, the eventuality of the Fed lowering rates can be exactly opposite if the markets expect that the Fed will reduce rates even further, and expect long term rates to go down. In this case, the longer end will outperform, which is due to the price increase of bonds in the longer end.
Outperforming here is in terms of price because generally, you expect traders to make money on price differences. They are not the kind of investors who would buy and hold Treasuries for the yield. They might not necessarily be short-term or high frequency traders, but they still trade to capture the price difference.
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Permalink Reply by Rom Badilla on -
Ray,
"why buy long term if short term gives same yield but less
commitment? *expected* price increase/decrease in long/short term
bonds? "
If the curve flattens and you are positioned correctly, you will experience price appreciation that is not captured in the yield to maturity calculation. This is inherent in the longer duration aka price sensitivity to interest rates of the longer maturity bond such as the 10-Year.
People often confuse yield or interest rates and assume that is the realized return when it only paints a partial picture. That yield is realized only if held to maturity and the fixed coupon payments are reinvested back into the security. During that holding period and is the case with most investments, bonds can still experience price fluctuations as market interest rates change, even though you are receiving a fixed coupon. I like to think of this as opportunity costs. If you buy a 5 percent paying bond and after the minute you buy it, rates jump to 10 percent, the appeal of your purchase just dropped dramatically. The only way to reflect that is to drop the price far enough in order to make the yield competitive and reflective of overall market conditions.
As far as this scenario and while the yield to maturities are similar, the longer dated maturity will experience price appreciation far greater than the shorter dated maturity securitiy. Once the curve flattens, the logical step is to consider exiting that trade and monetizing that gain in price. The question becomes is if the price appreciation gain that occurred in a fraction of the time is greater than the projected income that bond will generate. More times than not, the price gain will trump the coupon and will warrant an exit strategy.
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Permalink Reply by Ray Senko on
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Maulik/Rom,
First, thank you for your prompt and detailed responses; they have helped correct my understanding a great deal!
My questions stemmed from lack of understanding of the state of the yield curve when the bond buyer/seller assessed the market (steep) vs. what he expected (flattening). I mistakenly thought the curve was flat when the long buy/short sell was executed (which spurred my ‘identical yield, different maturity’ question), but now I see that it is *expectation* of the flattening which prompts the move. Your explanation of a1 covers my question a2 as well.
Thank you again for taking the time to explain these concepts. It will help me draw more from the Bondsquawk daily bond market recaps in general, and also in terms of QEII and how its effects on the stock/bond markets play out.
© 2012 Created by Maulik Mody.
