Wednesday, 19 September 2012

Government Bonds – The Tools

Now that you are equipped with the basic knowledge of trading SGS bonds, the next question to ask is when to buy or sell. To answer this question, you need to know the current yield relative to the historical range. A useful tool is to plot the cumulative distribution of the historical yields and the current yield. See the graph below.

The lines represent the cumulative distribution of the historical yields of all benchmark bonds while the triangles represent the current yield. Using the 3-month bill as an example, the average yield is about 1.5% historically while the current yield is less than 0.25%. As you can see, the current yields for practically all bonds are languishing at new historical lows except for the relatively new 30-year bonds. As bond prices move in opposite direction from interest rates, interest rates are likely to rise in the next few years and bond prices likely to drop (by a factor of Change in Interest Rate x Duration). Hence, significant potential losses exist for long-term bonds.

A second useful tool is to compare the spread between long-term and short-term bonds. Usually, a spread exists between these bonds, as longer-term bonds would need to offer higher yields to compensate investors for inflation in future. However, during certain periods, the spread could significantly widen or narrow beyond its usual range. This can give rise to potential trades in either long-term or short-term bonds. See the graph below.

In this graph, the blue line represents the yield of the shortest bill while the pink line represents the yield of the longest bond available (which could be the 15-year, 20-year or 30-year bond available at that time). The yellow line represents the spread between these 2 yields. As you can see, there is a range of between 1% and 3.5% in which the spread usually fluctuates. However, in Sep 2006, the spread was negative. A review of the long- and short-term yields reveal that this was a result of the short-term yield rising to meet the long-term yield. Such an anomaly is unlikely to continue for long and the strategy would be to bet that the short-term yield would decline to its usual range. Hence, the strategy would be to buy short-term bonds. Recall that the Change in Bond Price is approximately equal to Change in Interest Rate x Duration, you would want to pick the bond whose yield is as close to the short-term yield as possible while at the same time have as long duration as possible. This is actually a trade-off as the longer the duration (and maturity), the further away its yield will be from the short-term yield.

Consider another example in Jun 2008 when the spread reached the higher range of 3.5%. Here, the rise in spread was contributed both by a rise in long-term yield and a fall in short-term yield. Again, this high spread could not be sustained for long and either a fall in either long-term yield (which is profitable if you buy the bond) or a rise in short-term yield (which is loss-making if you buy the bond) or both would be likely. However, from the historical trend of long-term yields, the long-term yield at that time was not at the high-end of its range and it was possible that the long-term yield could move higher and result in a loss for bond holders. Similar, the short-term yield was at the low-end of its range and could potentially rebound. This transaction, while likely, is not a "sure" thing compared to the earlier example. As it turned out, the long-term yield fell while the short-term yield roughly held steady. Holders of long-term bonds would have made a profit.

The above are 2 useful tools for investment in SGS bonds. Hope they can assist you in investing in SGS bonds!

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