Government bond yields

Market makers in government bonds consider various factors in deciding how to run their books. Customer business apart, decisions to purchase or sell securities will depend on their views about the following  

These three factors are related but are aflFected diflFerently by market-moving events. A report on the projected size of the governments budget deficit, for example, will not have much effect on two-year bond yields, but if the projections are unexpected, they could adversely aflFect long-bond yields. The type of effect—negative or positive—depends on whether the projections were higher or lower than anticipated. 

Once investors have determined which part of the yield curve to invest in or switch into, they must select specific issues. To make an informed choice, they use relative value analysis. 

Relative value analysis focuses on bond issues located in certain sectors, or local parts, of the curve. Because a bonds yield is a function not just of its duration—after all, two issues with near-identical duration can have different yields—the analysis assesses other factors as well. These include liquidity, the interplay of supply and demand, and 

The figure shows that, when the curve is inverted, investors can pick up yield while shortening duration. This might seem an anomalous situation, but in fact, liquidity issues aside, the market generally disfavors bonds with high coupons, so these usually trade cheap to the curve. 

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The default spread in relation to the outright government bond yield... 

To assess the impact of changing yield spreads therefore, it is necessary to carry out a simulation on the effect of different yield curve assumptions. For instance, we may wish to analyse 1-year holding period returns on a portfolio of investment-grade corporate bonds, under an assumption of widening yield spreads. This might be an analysis of the effect on portfolio returns if the yield spread for triple-B-rated bonds widened by 20 basis points, in conjunction with a varying government bond yield. This requires an assessment of a different number of scenarios, in order to capture this interest-rate uncertainty. 

The Default Spread in Relation to the Outright Government Bond Yield... 

FIGURE 8.4 Correlation of theoretical yield spread with outright government bond yield, 10-year corporate bonds. 

FIGURE 10.1 Government bond yields. (Data source Bloomberg.)... 

Swap rates (frequently quoted as government bond yield for a chosen benchmark adjusted for swap spreads)... 

In this example, the bank is quoting an offer rate of 5-25 percent, which is what the fixed-rate payer will pay, and a bid rate of 5-19 percent, which is what the floating-rate payer will receive. The bid-offer spread is therefore 6 basis points. The fixed rate is always set at a spread over the government bond yield curve and is often quoted that way. Say the 5-year Treasury is trading at a yield of 4.88 percent. The 5-year swap bid and offer rates in the example are 31 basis points and 37 basis points, respectively, above this yield, and the bank s swap trader could quote the swap rates as a swap spread 37-31. This means that the bank would be willing to enter into a swap in which it paid 31 basis points above the benchmark yield and received LIBOR or one in which it received 37 basis points above the yield curve and paid LIBOR. 

In the U.S. and U.K. markets, the basis for comparison is the relevant government bond yield, which is semiannual. Equation (14.17) derives the equivalent semiannual yield. (See chapter 1 for a discussion of converting from one payment basis to another.)... 

The OAS-derived yield spread is based on the present values of expected cash flows discounted using government bond—derived forward rates. The spread berween the cash flow yield and the government bond yield is based on yields to maturity. The OAS spread is added to the entire yield curve, whereas a yield spread is over a single point on the government bond yield curve. For these reasons, the two spreads are not strictly comparable. 

Very conservative investments, such as government bonds, pay low returns in the range of 5 to 7 percent, but the risk involved is practically negligible. Preferred stocks yield returns of about 7 to 9 percent. There is some risk involved in preferred-stock investments since a business depression or catastrophe could cause reduction in returns or even a loss of the major portion of the capital investment. Common stocks may yield very high returns however, the returns fluctuate considerably with varying economic conditions, and there is always the possibility of losing much or all of the original investment. 

A common observation in government bond markets is that the longest dated bond trades expensive to the yield curve. It also exhibits other singular features that have been the subject of research, for example, by Pboa (1998), wbicb we review in this chapter. The main feature of long-bond yields is that they reflect a convexity effect. Analysts have attempted to explain the craivexity effects of long-bond yields in a number of ways. These are discussed first. We then consider the volatility and convexity bias that is observed in long-bond yields. 

From Figure 7.3, we see fliat to price a very Iraig-dated bond off the yield of the 30-year government bond would lead to errors. The unbiased expectations hypothesis suggests that 100-year bond yields are essentially identical to 30-year yields however, this is in fact incorrect. The theoretical 100-year yield in fact will be approximately 20-25 basis points lower. This reflects the convexity bias in longer dated yields. In our illustration, we used a hypothetical scenario where only three possible interest-rate states were permitted. Dybvig and Marshall showed that in a more realistic environment, with forward rates calculated using a Monte Carlo simulation, similar observations would result. Therefore, the observations have a practical relevance. 

In a conventional positive yield curve environment, it is common for the 30-year government bond to yield say 10-20 basis points above the tlO-year bond. This might indicate to investors that a 100-year bond should yield approximately 20-25 basis points more than the 30-year bond. Is this accurate As we noted in the previous section, such an assumption would not be theoretically valid. Marshall and Dybvig have shown that such a yield spread would indicate an undervaluation of the very long-dated bond and that should such yields be available an investor, unless he or she has extreme views on future interest rates, should hold the 100-year bond. 

Now let us imagine that the yield on a 100-year government bond with a coupon of 6.00% is 6.20%. This fits investor expectations that the very longdated bond should have a yield premium of approximately 20 basis points. This would set the price of the 100-year bond as ... 

The yield of a benchmark government bond depends on expected inflation rate, currency rate, economic growth, monetary and fiscal policy. Conversely, the spread of a corporate bond is influenced by the credit risk of the issuer, taxation and market liquidity. Moreover, the yield spread depends on other factors such as ... 

Figure 8.2 shows the Bloomberg YAS page for Tesco bond SVi% 2019, as at October 9, 2014. The bond has a price of 109.345 and yield to maturity of 3.46%. On the date, the yield spread over a government bond benchmark UK 41 % Treasury 2019 is 200 basis points. The G-spread over an interpolated government bond is 181.5 basis points. Conventionally, the difference between these two spreads is narrow. We see also that the asset-swap spread is 173.6 basis points and Z-spread is 166.3 basis points. 

This means that p f) is the expected value of the present value of the bond s cash flows, that is, the expected yield gained by buying the bond at the price p f) and holding it to maturity is r. If our required yield is r, for example this is the yield on the equivalent-maturity government bond, then we are able to determine the coupon rate C for which p r) is equal to 100. The default-risk spread that is required for a corporate bond means that C will be greater than r. Therefore, the theoretical default spread is C — r basis points. If there is a zero probability of default, then the default spread is 0 and C = r. 

In addition, market turmoil has created concern about the volatility in bond markets from the investor s viewpoint. Figure 10.1 shows the yield trend of the main government bonds in recent years. 

The most actively traded government securities for various maturities are called benchmark issues. Yields on these issues serve as reference interest rates which are used extensively for pricing other securities. Exhibit 1.2 is a Bloomberg screen of the benchmark bonds issued by the government of the Netherlands. European government bonds will be discussed in Chapter 5. As an illustration of a corporate bond. Exhibit 1.3 shows a Bloomberg Security Description screen for 4.875% coupon bond issued by Pirelli SPA that matures on 21 October 2008. 

There is no generally accepted definition of bondholder value. It could be set equal to the market value of a company s debt. The market value of outstanding debt could be increased by issuing more bonds. This would adversely affect the market value of existing debt. Alternatively, bondholder value is based on the yield spread to government bonds the wider the spread, the higher the risk associated with the issuer. A spread widening due to the company s activities leads to a reduction of bondholder value. 

Research studies found that risk premiums fall in an environment of economic prosperity and rise when conditions are poor. Lower-rated corporations usually have less diversified sources of income and thus are more sensitive to changes in the macroeconomic situation than higherrated ones. Risk aversion increases with rising uncertainty and leads to higher expected compensation in the form of additional yield versus government bonds. Hence the effects of a company s individual actions to increase bondholder value can only inaccurately be measured. On the other hand, the spreads based on prices of the financial markets have anticipative character and reflect the expectations of a broad average of market participants. 

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