Friday, 25 March 2016

How to Trade Bonds and Bank Bills

Basic Trading Concepts Defined

Bank Bill Rates and Government Bonds

As well as stock trading, it can be useful to consider trading fixed income securities such as bank bills, government notes and government bonds (e.g. US Treasury notes and bonds). The difference is that bank bills have a maturity of less than one year, government notes are between one and ten years, and government bonds are greater than ten years. The definitions of each can be found externally, but when trading a futures contract over them, their coupons etc become less relevant.

Bank Bill Rate

The first important thing is understanding why the price that you see in your trading screen is what it is. Bank bills are quoted as 0.95 (or 9550), and this is because the expected interest rate when that futures contract expires is 5% (one minus the price quoted in the screen equals that expected rate). So if rates are currently 4%, and the futures expiring next month are priced at 0.9575, traders expect interest rates to rise to 4.25% upon the next announcement (rates are normally increased or decreased 0.25% at a time). An overview of bank bill futures may look like this:

Expiry month
Implied rate
Slight chance of cut from 4% to 3.75% in Feb
Two rate cuts expected by March
Rates to be back to 4% by June
Good chance of rate rise to 4.25% by September
Two rate rises by December

Government Bonds
Government notes and bonds are also traded through futures contracts, and their price is dependent on their current yield to maturity (rather than current interest rates). To some extent, the yield reflects the average interest rate over the life of the bond. The futures contracts still expire periodically, but these can be rolled over (replaced with a new contract), unlike bank bills where the price does not change in between the interest rate announcement and the expiry of the contract later that month. With the bank bill, you would simply purchase a new contract expiring in a future month, and trade based on how you think interest rate expectations will change in between now and the next announcement.

The prices of all of these contracts rise when interest rate expectations fall, i.e. during recessions with low inflation, and the prices fall when expectations rise, i.e. during periods of strong economic growth and higher inflation. This inverse relationship between prices and yields is the most important thing to remember when trading them. Additionally, the longer the note/bond has until maturity (e.g. 20 or 30 year bond), the greater the change in interest rate expectations will change the price. This means that 30 year bonds change the most when economic data changes rate views, and one year notes change the least. This is known as duration, which is a topic that can be explored in-depth at another time.

Trading these interest rate securities can be based on whether interest rates will be held/cut/raised, economic data will be good/bad or whether a sudden surge of demand will force prices to increase. They offer, as their name suggests, far better exposure to rate changes and expectations that stocks do, and should therefore be considered in most trading portfolios.

Reference: David Pimm

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