Draft: June 8, 2003 Developing Efficient Market Infrastructure and Secondary Market of Government Bonds in Developing Countries

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4.2The investor’s trading needs

Nonetheless, the investor trades for its self-interests. With some yield sacrificed, what needs is the investor trying to fulfill by trading government bonds? The investor usually trade government bonds for earning of interest income, hedging of its position, rebalancing of its investment portfolio, speculation on the direction of an interest rate movement, arbitrage in unequilibrium market positions. Longer-term bonds are largely preferred for speculative trading, because they have a larger degree of price volatility and provide more trading opportunities over their life. All trading costs have to be low enough to easily allow the investor to serve these operational purposes.

The investor’s trading purposes are not static. As the trading purposes described above, the investor who heavily trades government bonds is almost always an institutional investor. Which purposes the investor actually pursues or how much a particular purpose the investor pursues varies, depending on the investor’s capacity, objectives, investment time horizon, risk tolerance, strategies, policies, market outlook, available instruments, and other factors. Furthermore, the boundaries of hedging, rebalancing, speculation and arbitrage are not necessarily distinct. An individual trading is a mixture of these purposes to varying degrees. Sometimes, a defined purpose of investment in a certain set of circumstances and assumptions turns out to be a different one as the circumstances changes. For example, a hedged fund may inadvertently become a speculative one as the Long Term Capital Management did.

4.3Macroeconomic functions

While the pursuit of private interests drives investors to trade government securities, the public, those who trade and those who do not trade alike, also benefits from active trading of government bonds thanks to the macroeconomic functions of a government bond market. These macroeconomic functions and their benefits cause the World Bank and IMF to recommend many developing countries to develop a government bond market as a basis for efficient and sustainable economic development.

A liquid secondary market of government bonds is expected to perform the following functions for public interests:

  • Lowering of financing costs of budget deficits in the medium- and long-term;

  • Signaling of the conditions of an economy;

  • Execution of monetary policies; and

  • Facilitation of market risk management, and diffusion of a concentrated risk;

  • Rational valuation of financial assets in an economy;

  • Facilitation of the development of a corporate bond market.

A liquid secondary market of government bonds helps the government lower financing costs of budget deficits in the medium- and long-term in case the government constantly has a sustainable level of budget deficit. A narrower bid/ask spread and a reduced liquidity premium allow new issues of government bonds to carry lower coupons on the average than the issues would otherwise carry.

A liquid secondary market of government bonds signals the current and prospective conditions of an economy. The yield of bonds traded in a liquid secondary market reflects the aggregate demand and supply relationship of the “risk-free” financial assets in the economy, and serves as the most important indicator for the macroeconomic management of a national economy.

A liquid secondary market of government bonds facilitates the execution of monetary policies. The more liquid the government bond market is, the more sensitive the market is to the monetary authority’s intervention in short-term financial markets, and thus the more efficiently a monetary policy is transmitted into the economy.

A liquid secondary market of government bonds possibly derives risk hedging transaction techniques or instruments such as short selling, futures, options or swap transactions. These techniques or instruments allow a market participant to transfer his/her risk to a more affordable party in the economy. Hedging will not be effective unless the market is liquid enough.

A liquid secondary market of government bonds provides the economy with a benchmark yield or yields of “risk-free” obligations against which assets of various classes are valued. This enables rational exchanges of different asset classes. The more heavily the bonds are traded, the more reliable the benchmark yield is.

Corporate bonds are a group of financial asset classes. The liquidity of corporate bonds is considerably limited, if not nil. The constant availability of a reliable benchmark yield helps price corporate bonds rationally at any time, facilitating the efficient reallocation of capital to productive economic activities.

Thus, the active trading of government bonds is intended to benefit the whole economy instead of only investors and the issuer or the government. Not only a government bond market but also other capital market are more or less the same in the sense that they are meant to serve public interests as well as private ones.

4.4A quantitative example of public benefit

Table 2 exhibits a list of selected government bond markets in developing countries whose secondary market activities the International Finance Corporation (IFC) closely monitored mainly from 1998 to 2001, and the bid/ask spreads of their 3- to 5-year government bonds on April 30, 2001. They are ones whose market data were considered as relatively consistent and reliable among those markets that IFC monitored closely during the same period.

Savings from a liquid government bond market will be significant. The column of the table shows how much they could have saved interest payments on their outstanding government bonds if they had made their markets more liquid and cut half the prevailing spreads3. The total saving would have been larger than calculated, because these calculations ignored possible reductions in market impacts and liquidity premiums due to more liquid markets. A market impact will be much less in a more liquid market. Investors will demand less for a liquidity premium.

Table 2: 3- to 5-year Government Bond Spreads in Selected Developing Countries

Govt Bond Outstanding

US$ mil

Bid/Ask Spreads

Market Impact

Liquidity premium

Assumed cut

Calculated savings

US$ mil










1.89 +








20.60 +








38.85 +








15.00 +








4.70 +








1.77 +

Source: IFC Bond database: April 30, 2001

* Indicative quotes. Actual spreads on a firm basis are considered to have been wider.

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