Trading in Government Bonds: Why and How

Checklist
This checklist outlines the ways in which government bonds are traded.

Definition
A government bond is a bond issued by a national government, denominated in the country’s own currency.
Sovereign bonds are those issued by foreign governments in their own currencies. Government bonds are
usually thought of as risk-free, because even if a government has problems it can always raise taxes or
simply print more money to redeem the bond. The maturities of sovereign bonds vary and will depend on the
issuing government. The US government is the largest seller of government or treasury bonds in the world.
Its bonds are auctioned in February and August, and have 30-year maturities.
In the primary market, bonds are sold in auctions. Bids are divided into competitive and noncompetitive
bids. Competitive bids are restricted to primary government dealers, while noncompetitive bids are open to
individual investors and small institutions.
Secondary market trading in bonds occurs in the over-the-counter (OTC) market. All US government
securities are traded OTC, with the primary government securities dealers being the largest and most
important market participants. In the secondary market a wide variety of investors use bonds for investing,
hedging, and speculation. These investors include commercial and investment banks, insurance companies,
pension funds, mutual funds, and retail investors.
While some electronic bond trading is available to retail investors, the entire bond market remains very much
an OTC market. The bond market, unlike the equity markets (where electronic dealing and transparency
have leveled the playing field for individual and institutional investors), lacks price transparency and liquidity,
except in the case of government bonds. For the independent bond investor who would prefer to spread his
or her risk and not pay the high fees for a managed fund, a good alternative is an exchange-traded fund or
an index bond fund, which will track government bond indices and, given the high liquidity of these bonds,
will present fewer problems than corporate bonds.

Advantages
• Price transparency and liquidity for government bonds are comparatively high, providing a safe
platform for a wide range of investors to hedge and speculate. These investors include commercial and
investment banks, insurance companies, pension funds, mutual funds, and retail investors.
• Government bonds are generally referred to as risk-free bonds, because governments can simply raise
more taxes or print more money to pay for them.
• Government bonds are highly liquid and investors can recover some of their investment quickly if
necessary.

Disadvantages
• There is foreign-exchange risk for investors when the currency of the bonds in which they have
invested declines in relation to their own.
• The risks of trading in government bonds stem, above all, from changes in interest rates, which can
cause fluctuations in prices for bonds.
• Bond prices are influenced by economic data such as employment, income growth/decline, and
consumer and industrial prices. Any information that implies rising inflation will weaken bond prices, as
inflation reduces the income from a bond.

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Action Checklist
• If you are investing in sovereign funds, how safe is the government or region? Don’t forget that in 1998
the Russian government defaulted on its debt.
• What are interest rates going to do? Investors who buy and sell bonds before maturity are exposed to
many risks, most importantly changes in interest rates. When interest rates increase, new issues will
pay a higher yield and the value of existing bonds will fall. When interest rates decline, the value of
existing bonds will rise as new issues pay a lower yield.

Dos and Don’ts

Do
• Before you buy, check how quickly you will be able to sell if necessary, and at what discount and
dealing fee.

Don’t
• Don’t unless you are completely confident, invest in only one type of bond. An exchange-traded fund or
an index bond fund might be a much safer bet.

More Info
Books:
• Faerber, Esmé. All About Bonds and Bond Mutual Funds: The Easy Way to Get Started. 2nd ed. New
York: McGraw-Hill, 1999.
• Rini, William A. Mathematics of the Securities Industry. New York: McGraw-Hill Professional, 2003.
• Wong, M. Anthony, in collaboration with Robert High. Trading and Investing in Bond Options: Risk
Management, Arbitrage, and Value Investing. Wiley Finance. New York: Wiley, 1991.

Articles:
• “Comment: Investment—Getting the best from bonds.” Pensions Management (April 2008). Online at:
findarticles.com/p/articles/mi_hb6599
• Lee, John P. “Bonds up on subprime speculations.” Article on TradingMarkets.com (June 2008).
• Rodier, Melanie. “The massive growth of electronic bond trading.” Wall Street & Technology (April 15,
2008).

Websites:
• Bloomberg.com: www.bloomberg.com/markets/rates/index.html
• FTSE Global Bond Index, a series of fixed-income indices covering the principal government bond
markets, global emerging, European covered, sterling- and euro-denominated corporate markets:
www.ftse.com/Indices/FTSE_Global_Bond_Index_Series
• Lehman Aggregate Bond Index: www.lehman.com

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