The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

Electronic trading

Much effort and money has gone into building electronic trading systems. By 2002, 81 screen-based bond-trading systems were in operation, some belonging to a single dealer and others bringing many dealers together. The market was unable to support so many competitors and many of these nascent electronic bond exchanges have failed. Electronic trading has been extremely successful in the government bond market, where the number of different securities is small and liquidity – the amount available for investment – is high. Electronic systems accounted for about three-quarters of trading in European government bonds in 2004. Most electronic systems also offer online trading of commercial paper, emerging-market bonds and other fixed income products. Trading of corporate and municipal bonds has proven surprisingly difficult to automate because of three characteristics of these markets. First, institutional investors often pursue strategies that require near simultaneous transactions. For example, an investor may wish to sell the Daimler Chrysler bonds in its portfolio and purchase General Motors bonds, which are currently cheaper. But this transaction is uninteresting unless the investor can complete both legs – it does not wish to sell Daimler Chrysler and then find that it cannot obtain the General Motors bonds. Such transactions may be difficult to consummate without discussion with dealers, whose inventories of bonds allow them to assure clients that the entire transaction can be completed. Second, obtaining full price information is a persistent problem in bond trading. As comparatively little bond trading occurs on exchanges, there is no way to ensure that all trades are publicly reported. In the corporate-bond market, only the dealer and its customer know the price at which a particular bond has traded. The prices posted by dealers and released to financial information providers may or may not reflect the prices at which trades have actually occurred.

Third, the number of bonds issued by companies, and by local governments and their agencies, is vast. A large corporation may have dozens of different bonds outstanding, each with different characteristics. Most of these bonds are traded rarely, if ever, after initial issuance. An investor posting an electronic offer to buy or sell such a security is unlikely to find a taker – in market parlance, trading in such issues is illiquid. The investor may be better served by talking to a dealer, who may be willing to trade the bonds or may know of another investor prepared to buy or sell that specific issue. Electronic trading is likely to lead to increased price transparency, at least for some types of securities, and this will help reduce investors’ costs. As the technology develops, electronic trading systems may take on an important role in the dealing of large, heavily traded issues. However, they are unlikely to be an efficient way of buying and selling the millions of smaller bond issues outstanding. The existence of this enormous variety of bonds will continue to assure a role, albeit a lesser one, for bond dealers.


Central banks have made considerable efforts to shorten the time between execution of a trade and the exchange of money and payment. The shorter the settlement time, in general, the lower is the risk that a bank or securities firm will be harmed by the collapse of another firm with which it has traded. Central banks in wealthier countries are encouraging traders in government securities to settle no later than the next business day. Such an effort in Japan has led to about three-quarters of all trades settling before 10am on the following day; in December 2001, only 240 of 161,796 trades failed to settle within 24 hours.

Structured securities

Bonds that have options attached to them are called structured securities. Callable, putable and convertible bonds are simple examples of structured securities. Another traditional example is a warrant bond, a bond which comes with a warrant entitling the holder to buy a different bond under certain conditions at some future date. Many structured securities are far more complex, featuring interest rates that can vary only within given limits, can change at an exponential rate or can even cease to be payable altogether in certain circumstances. The prices of such instruments can be difficult to calculate and depend heavily on the value attached to the option features.


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