Government bonds trading

When the rates have been established they must then be calibrated. The calibration procedure is achieved using the observed market price of a bullet government bond and pricing the bond using the tree calculated rates to obtain the appropriate discount factors. As an example, consider a government bond trading at par and offering a coupon of 4.625% paid semi-annually. On maturity the bond will be redeemed for 102.3125, which is made up of the bond s face value, say 100, and one half of the annual coupon, 2.3125. 

This chapter examines a number of issues relevant to participants in the fixed-income markets. The analysis presented is based on government-bond trading and is confined to generic bonds that are default-free, with no consideration given to factors that apply to corporate bonds, asset- and mortgage-backed bonds, convertibles, or other nonvanilla securities, or to issues such as credit risk and prepayment risk. Nevertheless, the principles adduced are pertinent to all relative-value fixed-income analysis. 

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. 

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. 

We will illustrate the sources of euro returns using an example. In early July 2003, the 5-year German government bond (i.e., bund) was trading at 100.103 assuming a settlement date of 9 July 2003. The security description screen from Bloomberg is presented in Exhibit 3.8. This bond carries a coupon rate of 3% and matures on 11 April 2008. Cou-... 

The Euro market has not only become the largest government bond market in size but also in number of issues. This market had in February 2003 over 250 liquid issues (over 1 billion outstanding and 1-year maturity), significantly more than the 108 issues in the Treasury market or the nearly 170 JGB issues. There are just around 25 liquid issues trading in the UK gilt market. 

Many Euro government bonds can be stripped, breaking them down into each of the single payments that they involve, that is, one flow for each remaining coupon payment and another one for the principal. With this procedure an n-year maturity coupon-bearing bond is transformed into n + 1 strips (zero coupon bonds), which can be traded separately in the market. Yet this market is much less liquid in the Eurozone than in the United States. 

As at the start of 2003, no moves have be made to reinstate the Jumbo contract and presently the only way to effectively hedge ones exposure to the Pfandbrief market is via the swaps market, although many still favour the peripheral government bond route, particularly for trades conducted on a short-term horizon. 

A stock loan transaction in which the collateral is in the form of cash is similar in some ways to a classic repo trade. Here we compare the two transactions. Consider the following situation ABC is an entity, perhaps a bank or fund manager, that owns government bond G. Bank XYZ is a bank that requires bond G in order to deliver into a short sale that it has transacted in G. To temporarily acquire bond G to cover the short sale Bank XYZ may enter into either a stock loan or a classic repo. Exhibit 10.13 looks at the similarities between the two and the differences. 

The size of the repo market reflects the size of the cash market in government bonds, which is the largest in Europe. The instruments used in the market are listed in Exhibit 10.26. Securities marked with a are listed by ISMA as Euro GC securities. Most transactions are one-week maturity, while, unusually for repo, overnight trades are rarer. This may be because stamp duty is chargeable at a flat rate on domestic deals, and so this is an incentive for market participants to undertake longer-dura-tion repo trades. 

The Bund future was launched on 29 September 1988. With the introduction of the German government bond futures contract LIFFE was now trading bond contracts in the US Treasury bond, the Japanese government bond, the Italian government bond and UK gilts. It was the first financial futures exchange to have achieved this position. The contract specifications on the UK and European bond futures offered at that time appear in Exhibit 16.1. 

As explained in Chapters 19 and 16, swaps and futures contracts represent one of the easiest and most effective methods of managing a portfolio s duration exposure. Government bond futures is a frequently traded and extremely liquid contract in Europe, and investors can buy futures to increase duration, and sell futures to reduce the duration of their portfolio incurring minimal transaction costs. 

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. 

Credit default swaps can be used to trade credit spreads. Say investors believe the credit spread between certain emerging-market government bonds and U.S. Treasuries is going to widen. The simplest way to exploit... 

The market quotes bonds with embedded options in terms of yield spreads. A cheap bond trades at a high spread, a dear one at a low spread. The usual convention is to quote the spread between the redemption yield of the bond being analyzed and that of a government bond having an equivalent maturity. This is not an accurate measure of the actual difference in value between the two bonds, however. The reason is that, as explained in chapter 1, the redemption yield computation unrealistically discounts all a bond s cash flows at a single rate. 

In the United States, Canada, and New Zealand, indexed bonds can be stripped, allowing coupon and principal cash flows to be traded separately. This obviates the need for specific issues of zero-coupon indexed securities, since the market can create products such as deferred-payment indexed bonds in response to specific investor demand. In markets allowing stripping of indexed government bonds, a strip is simply a single cash flow with an inflation adjustment. An exception to this is in New Zealand, where the cash flows are separated into three components the principal, the principal inflation adjustment, and the inflation-linked coupons—the latter being an indexed annuity. 

Providing a framework to analyse the trade-off between risk and return, this model calculates the rate of return that investors will require in order to compensate for the risk involved with investing in a particular firm (as opposed to investing in risk-free government bonds). This measure is known as a firm s cost of capital. Firms tend to utilise the model themselves when considering prospective stocks for investment. A finance department may also wish to determine the return required by shareholders in their own firm, ensuring that they only pursue projects meeting this expectation. 

The bank or corporation enters into cash-settled contract for difference (CFD), which pays out in the event of a rise in government IL bond yields. The CFD has a term to maturity that ties in with the issue date of the IL bond. The CFD market maker has effectively shorted the government bond, from the CFD trade date until maturity. On the issue date, the market maker will provide a cash settlement if yields have risen. If yields have fallen, the IL bond issuer will pay the difference. However, this cost is netted out by the expected profit from the cheaper funding when the bond is issued. Meanwhile, if yields have risen and the bank or corporate issuer does have to fund at a higher rate, it will be compensated by the funds received by the CFD market maker. 

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