MOVE Index - An index of fear for the bond market

It may come as a shock to many people to know that the bond market is larger than the stock market. According to data collected by SIFMA (Securities Industry and Financial Markets Association), in 2021 the US bond market was estimated at $47 billion. For comparison, the capitalization of American companies is approx $40 billion. Therefore, it is worth paying attention to what is happening in the bond market. There is an index that is a bond "VIX". Talking about MOVE Indexwhich will be the main topic of this article.

What are bonds?

A bond is a debt security in which the issuer undertakes to repay the bond at a nominal value within a specified period. Bonds can be coupon (they pay interest in accordance with the agreement, e.g. every quarter) or zero-coupon (sold at a discount to the nominal value). Bonds may issue:

• government,
• local government,
• enterprises.

Bonds are issued as an alternative to bank loans and credits. In the United States, corporations like to use this method of financing. With the growth of this market, more and more "exotic" solutions appeared, which allowed to offer issuers or buyers of bonds greater flexibility.

There are bonds with special rights. An example is bonds giving the right to redeem the bonds by the bondholder (bond buyer). This type of bond is called callable bonds. There are also bonds that give the issuer the right to redeem the bonds ahead of schedule (so-called putable bond). In addition, there are also convertible bondswhich enable the conversion of bonds into the issuer's shares at a predetermined conversion rate.

Bonds can also be divided into those with a variable interest rate and fixed interest rate. Variables are usually constructed as follows: market interest rate + margin. If interest rates rise, the interest paid by the bond issuer increases. In the case of fixed-coupon bonds, a change in interest rates does not affect the size of the coupon paid. Thus, a change in interest rates has a significant effect on the prices of fixed-coupon bonds.

READ: How to invest in contracts for treasury bonds? [Guide]

Bonds - three types of risk

There are three main risks associated with the financial markets. The risks listed below usually move together, which translates into changes in the price of bonds.

The first is risk related to the duration of the investment (so-called duration risk). This is a risk with the answer to the question:

"When will I get my money back?"

This risk is clearly visible on the bond yield curve. In normal situations the longer the maturity of the bonds, the higher the risk premium is demanded by investors. This is due to the fact that if an investor lends a company money (e.g. buys bonds) for two years, he is able to approximately estimate the risk of inflation. However, if the same investor is considering buying bonds with a maturity of 20 years, he has no idea what inflation will look like in two decades.

Another risk that affects the interest rate on bonds is credit risk. In other words, it is the risk of default by the debtor. The longer the time to maturity, the premium increases (it is not known how the debtor will manage his finances in the long term). Credit risk is also affected by the current credit rating of the debt issuer.

The last risk is bond bulge risk, i.e. the sensitivity of the bond price to changes in the market interest rate. The convexity of the bond varies with different parameters. The lower the interest rate on bonds, the greater the sensitivity of the price to changes in the interest rate. The longer the maturity date, the greater the sensitivity of the bond price to changes in the market interest rate.

Interest rates and bond prices

An increase in interest rates causes the price of fixed-coupon bonds to fall. This is due to arbitration practices. If a fixed rate bond (A) and a floating rate bond (B) have the same parameters (time to maturity, current yield, risk and price), then an increase in interest rates makes it more advantageous to have a floating rate bond in the investment portfolio. This is because the price of both bonds is the same and the floating rate bond (B) will pay higher interest. An arbitrage transaction involving the sale of fixed-coupon bonds and the purchase of floating-coupon bonds seems natural. For this reason, an increase in interest rates causes bond prices to fall.

In the case of a decrease in market interest rates, the situation is reversed. It is much more advantageous to sell a floating rate bond and buy a fixed rate bond. This is because falling rates cause the coupon value of floating rate bonds to become lower. By contrast, the coupons paid by fixed coupon bonds do not change. Therefore, there is an increase in demand for fixed-coupon bonds. As a result, their prices increase.

It is therefore known that an increase in interest rates will have an adverse effect on the price of a portfolio of fixed-rate bonds. Investors can therefore use derivatives to hedge against the risk of falling bond prices. One of the solutions is the purchase of options that will protect the portfolio against a decrease in the value of the portfolio of debt securities.

With the increase in computing power, more and more analyzes have appeared on the impact of changes in interest rates on the value of bond options. Over time, indices were developed to measure sentiment in the options market. The most popular of these is the MOVE Index. The MOVE Index is basically the "bond" equivalent of the much more familiar one volatility index - VIX.

MOVE Index - VIX for the bond market

Most volatility headlines are sacrificed VIX indexwhich measures volatility in the stock market. However, there is another index that measures bond market volatility in a similar way.

MOVE estimates the future volatility of the yield (and therefore the price) of US government bonds. The calculations are based on the current price of Treasury bond options. For the purpose of proper calculation, options with different maturities (both short-term and long-term) are taken into account. Implied volatility measures the cost of hedging against a change in interest rates (up or down).

MOVE was designed in the 90s as a tool to measure sentiment changes in the bond market. The MOVE index has a long history of providing strong sentiment signals in the bond market. Merrill Lynch Option Volatility Estimate measures the volatility of the US bond market. The measure used is the spot price of one-month options on 2-, 5-, 10- and 30-year US Treasuries.

Very often, the MOVE Index provided strong signals heralding a change in monetary policy Federal Reserve. According to data provided by T. Row Price analysts, the MOVE index reached a minimum two months before the Federal Reserve began to cut interest rates. MOVE was a good indicator during the “pauses” in the tightening cycle (June 1989, June 1995, September 1998, January 2001 and September 2007).

Source: troweprice.com

Many investors and analysts closely follow the movements of the MOVE index. An example is Harley Bassmann (creator of the index) who, while still an employee of Bank of America/Merrill Lynch, mentioned that MOVE is “canary in the mine”.  Due to its sensitivity, the index is very often analyzed by traders in the bond market. It is worth mentioning, however, that what is happening on the debt instruments market also resonates with the perception of risk on the stock market. For this reason, some stock analysts also look at the behavior of this index to try to better predict price changes in the stock market.

Summation

MOVE Index is the VIX of the stock market. He had periods in his history when he "predicted" a change in monetary policy by the Fed. For this reason, in a world of higher interest rates, it is worth checking from time to time whether there have been any significant changes heralding the start of a softer monetary policy.

It is worth remembering that the bond market is larger than the stock market. For this reason, changes in bond prices have a significant impact on financial markets, including equities. Therefore, monitoring the MOVE index may also be a good idea for investors in the stock market.

Interestingly, the index changed hands over 3 years ago. In 2019, Intercontinental Exchange Inc. published information on the acquisition of several indices measuring the volatility of fixed-rate debt instruments. One of the indexes acquired was the Merrill Lynch Option Volatility Estimate (MOVE).