question on govt bonds

Discussion in 'Economics' started by new0214, Apr 30, 2009.

  1. new0214


    Here are quotes from a report on Indian govt bonds –

    QUOTE 1

    ‘If you could look at the spread for five-year AAA versus the 10-year, the spread compression has happened more at the five-year AAA corporate bond as compared to the 10-year. Therefore I believe that there is some juice left on the ten-year AAA corporate bond as compared to the five-year.’

    My Question1 - Please explain what is spread compression, and why is less spread compression better

    QUOTE 2

    ‘Govt has introduced small steps like exchange traded futures strips which will all go long way in deepening bond market’

    My Question 2 - What is exchange traded futures strips


    Question 3 – What are the reasons why bond prices rise.

    I know one reason - its because IR may come down and everybody chases the higher coupon bond,.

    Is this another reason ? govt bonds are redeemed . Does this mean that there is more money in the system which automatically lowers the Interest Rate ? Or is it so that there are less bonds in the system so the value for bonds go up.

    Is this another reason ? If the ec is booming we can expect the bonds to rise. But Why ?
  2. Lots of questions there...

    Q1: The spread referred to here is the difference between the AAA bond yield and the comparable govt bond yield. Simplistically, the lower the yield spread of a risky asset (like the AAA bond) over a govt bond, the less risky and the more like a govt bond it is.

    Q2: I would assume they're referring to some sort of an exchange-traded IR futures, which would provide better liquidity and more instruments for hedging IR risk.

    Q3: It's a complicated dynamic, but you need to think about it in terms of both fundamental valuations as well as supply and demand. On the one hand, if interest rates rise (fall), bond prices fall (rise), because you need to apply a higher (lower) discount rate to the bond cashflows. On the other hand, the forces of supply and demand matter, as well. For instance, issuance is supply, whereas redemptions/coupon payments are equivalent to demand, because they reduce the notional amount of bonds left in the mkt. The dynamics of how the economic situation influences bond yields is more complicated, esp now. Normally, when an economy is booming, you can expect bond prices to fall, since there will be more demand for riskier assets, like equities. However, recently the effect has been reversed. Now eco doing better means less need for additional capital, so less bond supply, which actually causes bond prices to rise.