CHAPTER 19 Government Bond Analysis, the Yield Curve, and Relative-Value Trading

This chapter examines a number of issues relevant to participants in the sovereign fixed-income markets. As it is based on AAA-rated government trading experience, the analysis is confined to generic bonds that are for practical purposes default-risk free. There is no consideration of factors that would apply to corporate bonds, asset- and mortgage-backed bonds, convertibles, and other nonvanilla securities, and issues such as credit risk or prepayment risk.

The chapter is broken down as follows: first we consider the redemption yield and duration. This is followed by observations on the implied spot rate and market zero-coupon yields, relative-value trading, and butterfly trades.

THE DETERMINANTS OF YIELD

The yield at which a fixed-interest security is traded is determined by the market. This determination is a function of three factors: the term-to-maturity of the bond, the liquidity of the bond, and its credit quality. Government securities such as Treasuries are default free, and so this factor drops out of the equation. Under “normal” circumstances, the yield on a bond is higher the greater its maturity, reflecting both the expectations-hypothesis and liquidity-preference theories. Intuitively, we associate higher risk with longer-dated instruments, for which investors must be compensated in the form of higher yield. This higher risk reflects greater uncertainty with longer-dated bonds, ...

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