What FX traders should know about the government bond market
The government bond market, also known as the treasury market, is an integral part of the foreign exchange market.
For a cash settlement, FX traders can deal in bonds that domestic and international issuers issue from countries around the globe.
Regarding liquidity, spreads between bids and offers have been steadily decreasing over time, while trading volumes have steadily increased over time.
This means that it has become easier to trade in this asset class for most banks.
A trader can access local markets through direct access or many electronic information providers covering all major cash and derivatives markets worldwide.
The majority of these providers produce screens displaying live prices and indication-of-interest levels, which form the basis for bidding activity; they provide further information on trade reports, volume and market depth.
What’s Unique about Government Bonds?
The government bond market has a few unique qualities that set it apart from other financial markets.
For example, many issues are not actively traded or have very illiquid secondary markets, making the primary market the only viable option for FX traders.
Because counterparties in this market are generally restricted to government institutions (such as central banks) and other authorized dealers (including money managers like mutual funds), contracts should be tailored around the specifics of these participants’ needs.
Some of the most heavily traded instruments in this asset class include Treasury bonds issued by Japan, U.S., UK, Canada; Bunds including German government securities; Australia’s 10-year bond; France’s OAT; and Italian government securities.
In total, there are about 14 million outstanding government bonds from around the world.
While the U.S. Treasury market remains the world’s largest bond market with an estimated $10 trillion outstanding as of 2013, other countries have been catching up quickly.
Japan has become one of the fastest-growing debt issuers in history and is now second only to the U.S for this distinction. India has emerged as a major global player over recent decades due to its dynamic economic growth.
Common ways to trade
The most common way to trade this asset class is through traditional forward contracts that settle on specific future settlement dates (usually quarterly or semi-annually).
During their life, however, they can be traded just like regular cash market instruments. Some of the reasons a trader might choose to take this route include:
Being able to lock in the transaction price before it settles can help manage exposure or hedge foreign exchange risk.
You have the ability to trade these instruments for potential capital gains instead of interest rate swaps, swaps options and other derivatives.
In addition to forwarding contracts, there are also ‘To Be Announced’ (or ‘TBA’) transactions offered by most government bond dealers that allow FX traders to purchase specific bonds whenever they want during a fixed time frame.
These trades can be executed through brokers who use their inventories and those belonging to the interbank market – often resulting in better prices than going directly into this market.
Another option is utilizing a forward foreign exchange agreement in which transactions are made at a pre-agreed price but settled in regular spot FX, not actual bonds.
Because of the financial crisis, it is now more difficult to find banks willing to take the counterparty risk involved when trading TBA transactions from non-bank dealers.
In addition, executing these trades properly requires knowledge of the market conventions, including who takes the other side of each trade (known as ‘the taker’), how many contracts will be traded, and any guidance on price ranges.
Some brokers, for example, might offer different prices at different times during certain hours. It can also require using multiple brokers to make one trade depending on the specific requirements of the transaction; there are even instances where a trader might need to use two separate FX brokers to get the job done.
Another option is ‘Spot B-B’, which allows traders to buy and sell bonds settled in cash on a specific future date.
Even though their values move fast relative to other assets, government bonds tend to be less sensitive than stocks and some other asset classes when it comes to changes in interest rates; this helps reduce volatility while increasing liquidity.
However, they usually pay lower returns than corporate and treasury securities (usually between 3% for 10-year treasury bonds and 7% for short term euro issues).