Sovreign versus Corporate Bond Yield

[Sigma-D]

Today's bond sales show falling yield in both EZ and UK which is indicative of an increasingly risk off environment and money flowing into sovereign bonds. What I don't get is that corporate bonds are offering increasing yield as presumably appetite for corporate risk reduces. Are traders able to capitalise on this divergence of yield spread between the two classes of bonds or do market mechanics already factor in such things making profitable plays impossible?

 

[Martinghoul]

Who says that there's a divergence of yields? Since the 2009 and then the 2011 high the spread between corps and guvvies has been compressing relentlessly. Recently, there's been a very small bounce, but it's pretty insignificant. If you wanna chart, I can get smth.

 

[Sigma-D]

Who says that there's a divergence of yields? Since the 2009 and then the 2011 high the spread between corps and guvvies has been compressing relentlessly. Recently, there's been a very small bounce, but it's pretty insignificant. If you wanna chart, I can get smth.

Not my area at all, but noted there were a number of comments about corporate bonds dropping in price (higher yield) as they search for funds and noted this morning's sovereign bonds were going for lower yield (higher prices) and assumed the money flow was into sovereigns - not necessarily out of corporate - but that this was an indication of a general risk-off scenario. This opinion formed purely on what's being reported today.

I'll take your word for it that it's a temporary and insignificant blip on an otherwise compressing yield curve.

But my question still stands if there is an answer - can the spread between the two be traded?

 

[Martinghoul]

So lemme just show you what I mean exactly. I attach the charts of this corp-sov spread in EUR (top) and GBP (bottom) (the source is a little old, but the data is roughly in line).

The spread between the two can definitely be traded and is, in fact, traded quite a lot. Obviously, the specifics would very much depend on the context.

 

[Sigma-D]

Were the peaks in 2008 and 2011 flights to safety? 2008 I get, but 2011 - what did I miss?

Thanks for posting the charts. Extremely interesting. Are they based on spreads for a single term (5, 10, 15 year bonds) or a composite?

If there was a view that the short term was not representative of the expectations over the longer term i.e. the spread is compressing (generally) now, but is expected to diverge over the next 10 years, could you put together a trade not only on the spread between the sovereigns and the corporate bonds, but also with a combination of short and long dated instruments from each class to construct a trade that would capitalise on that expectation? I imagine if this is the case, you could create a profile for just about any view or expectation and design some fairly complex setups.

For the record, I can’t even trade spot forex successfully yet, but the possibilities for the wider universe of trading are genuinely exciting.

 

[Martinghoul]

Were the peaks in 2008 and 2011 flights to safety? 2008 I get, but 2011 - what did I miss?

Thanks for posting the charts. Extremely interesting. Are they based on spreads for a single term (5, 10, 15 year bonds) or a composite?

If there was a view that the short term was not representative of the expectations over the longer term i.e. the spread is compressing (generally) now, but is expected to diverge over the next 10 years, could you put together a trade not only on the spread between the sovereigns and the corporate bonds, but also with a combination of short and long dated instruments from each class to construct a trade that would capitalise on that expectation? I imagine if this is the case, you could create a profile for just about any view or expectation and design some fairly complex setups.

For the record, I can’t even trade spot forex successfully yet, but the possibilities for the wider universe of trading are genuinely exciting.

2011 was the European sovereign crisis.

The charts are the composite version of the spread. I can plot the individual maturity spreads relatively easily, as well.

And yes, you can trade the "term structure" of these spreads, for sure. People do that, but you have to be aware of the complexities of such trades (they don't just reflect the mkt's expectations for the spread).

 

[Sigma-D]

Would I be right in thinking this is a predominantly or purely professional area and is rarely traded be non-pros?

 

[Sigma-D]

My reason for asking is that I have assumed trading spot forex is about as easy as it gets because it's made easy for anyone to sign up with a broker, deposit funds and trade. But the reality, it's quite difficult. I see oceans of information on all sorts of things sloshing back and forth each day and can see connections and correlations that must offer opportunities. But if these are not within the reach of non-professionals then I'd be wasting my time considering them.

 

[Martinghoul]

Yes, you're correct in a sense that these instruments are "traded" mostly by professionals. Regular people mostly treat these things as longer-term investments.

And yes, FX is accessible and deceptively simple. In reality, you could generally say that the more liquid things are, the tougher they are to trade. And FX is, arguably, the most liquid asset class out there.

 

[Sigma-D]

In reality, you could generally say that the more liquid things are, the tougher they are to trade.

Stopped me in my tracks. I've been mulling this one over.


I thought liquidity was generally thought to facilitate trading. Why would it make it more difficult? The only factor I can hopefully half-sensibly come up with as to why this might be the case is the inability to accurately assess fair value in highly liquid markets. Price discovery is a consensus building exercise where an approximation to fair value is reached and trade is transacted. There has to be consensus or no trade is transacted.

Even the best econometric models running across an acre of super-computer power will possibly find it difficult if not impossible to assess a fair value for a currency exchange rate between any two countries. If this is the case then the drivers for forex specifically are presumably speculative and technical rather than fundamental. We’re trading random noise.

Am I anywhere near the right ballpark let alone in it?

 

[A Dashing Blade]

Would I be right in thinking this is a predominantly or purely professional area and is rarely traded be non-pros?

All (ie can't remember seeing one that hasn't) corp bonds have a minimum size, typically this is 10,000-50,000

 

[Martinghoul]

Stopped me in my tracks. I've been mulling this one over.


I thought liquidity was generally thought to facilitate trading. Why would it make it more difficult? The only factor I can hopefully half-sensibly come up with as to why this might be the case is the inability to accurately assess fair value in highly liquid markets. Price discovery is a consensus building exercise where an approximation to fair value is reached and trade is transacted. There has to be consensus or no trade is transacted.

Even the best econometric models running across an acre of super-computer power will possibly find it difficult if not impossible to assess a fair value for a currency exchange rate between any two countries. If this is the case then the drivers for forex specifically are presumably speculative and technical rather than fundamental. We’re trading random noise.

Am I anywhere near the right ballpark let alone in it?

Roughly speaking, yes, you're in the right ballpark.

It's a complicated point, but the relevant question you have to think about is the following. When you do a speculative trade (not to be confused with a hedge), what sort of a statement are you making? I would suggest that, implicitly or explicitly, by transacting in the mkt you're stating that the mkt price at which you've traded is wrong. So in order for you to trade, you either a) need a mkt with some dislocations/mispricings; or b) need to be able to predict the future better than the other people in the mkt. Regarding a), the more liquid the mkt, the less likely such dislocations/mispricings are to be present. As to b), I would refer you to a famous saying by Nils Bohr: "Prediction is very difficult, especially if it's about the future."

 

[Sigma-D]

My strike rate on option (b) is about 50/50 strangely enough. I manage to mangle it to well below par by picking the wrong times and places to enter, and exit, and by moving my stops in too close, too quickly, or not close enough, or quickly enough.

As for (a) I presume although mispricings/dislocations offer greater opportunities for constructing a trade, they offer less facility for doing so profitably as you swing further along the liquidity spectrum. If that was a correct assumption, I'm sensing a distribution curve of liquidity where the majority of traders focus on trading assets and instruments roughly halfway between the totally liquid to ridiculously illiquid spectrum? Illiquid enough to provide opportunities, but not so illiquid as to prevent you getting size on.

As the openings for a small fry like me to trade anything other than spot forex are limited, I'd better get rather good rather quickly at direction, timing and risk management in what is effectively, from my perspective, a directionless and almost random market.

Thanks for your response martighoul. Extremely interesting.




PS. Were Nils Bohr and Yogi Berra related?

 

[Martinghoul]

You're 100% spot on...

And as to the source of the quote, it's interesting you bring this up. I found this here:
http://quoteinvestigator.com/2013/10/20/no-predict/

 

[Sigma-D]

Berra's was a little more prosaic "The future ain't what it used to be".