How Does an Intermediate Government Bond Work?
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What It Is
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An intermediate bond is a note. Bonds refer to maturities in excess of 10 years. When traders refer to intermediate notes, they're usually discussing the notes issued by the United States Department of the Treasury and guaranteed by the full faith and credit of the United States. There are other government issuance, and these notes are backed by an implicit guarantee of the United States. However, they represent different United States agencies, and the first guarantee is a dedicated revenue source. This is the case with Federal Home Loan Bank paper that is used for loans to farmers, the Export-Import Bank that loans to trading companies, and the paper of agencies such as Fannie Mae and Freddie Mac that make loans to homeowners.
Bellwether Bonds
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All government intermediate bonds are issued as part of a refunding plan announced by the United States treasury on a quarterly basis. The important issues are the two-year note, the five-year note, the seven-year note and the 10-year note. Traders use these bellwether issues to hedge existing positions they may own in mortgage bonds, corporate bonds and foreign bonds. For example, the seven-year treasury issue is large and well received by the investing public. Traders of mortgage paper hedge or reduce their interest rate risk by shorting or selling the seven-year treasury while being long an equivalent amount of mortgage paper. Why short 30-year mortgages with seven-year paper? Because the average homeowner with a 30-year mortgage only lives in the house for about seven years. That's the average life of a 30-year bond and, hence, its realistic maturity. As a trader sells the mortgages, he buys back the treasury paper he purchased. The 10-year is often used to hedge corporate bonds. The two- and five-year treasury are traded in opposition to each other as the yield curve rises and narrows.
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Term Structure
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The term structure of interest rates is an important concept in treasury issuance. Depending on what part of the business cycle we're in, traders attempt to profit by betting on the relationship of the various maturities to each other. As business and inflation fears rise, the treasury yield curve flattens, making shorter maturities yield more than longer maturities. (Remember that bond prices and yields are inversely proportional.) When business slows, the reverse takes place and investors must stretch their maturity horizon to gain yield.
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