The topic of government bonds is ignored or at least underestimated by most newcomers and even by advanced traders. At the same time, government bonds are a great instrument for using the economy of a state for its own trading or to make a passive investment. In this article, we'll show you what to look out for to trade bonds successfully.
What are government bonds?
Government bonds are issued to raise capital without having to deposit special collateral. States issue bonds when they need funds to buy public goods such as schools, roads, jets or theatres. Government bonds are thus in the broadest sense credit transactions, whereby the state is the debtor and the buyer is the creditor. An interest rate is set for this loan transaction for a specific maturity.
#1 Relationship between credit rating and interest rate
The relationship between creditworthiness and interest rate is simply explained: The better the credit rating, the lower the interest rate and vice versa. The credit rating is the creditworthiness and is thus an indicator of the risk. Of course, the risk is higher with a bad credit rating than with a good credit rating. This risk is rewarded by a higher interest rate. In other words, anyone who wants a particularly high interest rate will have to buy this at a high risk.
#2 Relationship between interest rate and bond price
The interaction between interest and price must be understood when trading government bonds.
If the interest rate falls, then the bond price rises and if the interest rate rises, then the bond price falls. So there is a very high negative correlation between interest and price.
Since one cannot trade the interest rate separately, but only the bond, this mechanism must be internalized, if one has an assumption about the interest rate development. So if you start from rising interest rates, then you have to shorten the bond. If one anticipates falling interest rates, one should buy the bond.
#3 Relationship between interest rate and maturity
Government bonds are issued with different maturities and each maturity usually has a different interest rate. What may sound confusing at first glance follows a simple logic: The longer the maturity, the higher the interest rate and vice versa.
But why is this? Long-dated bonds are riskier than short-dated bonds because holders of long-dated bonds have to wait longer for the repayment of the sums available. If a holder of a long-dated bond needs his money before the due date, he has no choice but to sell his bond to someone else, possibly at a lower price. In order to compensate for the associated risk, long-dated bonds generally pay higher interest rates than short-dated ones.
#4 Yield curve
The yield curve is nothing more than the sequence of all maturities and the associated interest rates. The result is the yield curve, which currently looks like this for U.S.:
The yield curve changes over time, it can become steeper or flatter. In times of rising interest rates, the yield curve will tend to flatten and tend to steepen in times of falling interest rates. This fact can be exploited by trading bond spreads, so-called Flattener and Steepener.
How can I find out more about government bonds?
We recently published a course on bonds and you can look at it here: