In the summer of 2004 American bank Citigroup sold e11 billion of eurozone government bonds in two minutes flat and 30 minutes later cheekily bought back e 4 billion. It netted itself a handsome profit on the deal – and got itself in hot water with the regulators. The trade illustrates the kind of size you need to think about if you want to throw the bond markets around. Another way to get a sense of the magnitude of the government markets is to look at total outstandings, which for the UK’s gilt market alone are £694 billion. The result is a depth equity markets simply cannot rival.

The liquidity of bonds is possibly only matched by the foreign exchange markets. If you want to deal in a market free from the distortions of market-moving trades, bond markets are the place to be. Yet fixed income markets make up only a small part of the trading world of private investors. At the main spread betting companies bond products make up around 5% of turnover, while for the execution-only brokers the share is less than one-half of one per cent.

Think about the future

The greatest interest from personal account players lies in the futures markets, which provide liquid and easy trading, and the crucial ability to go short as well as long. In fact if an investor wants to go short futures are the only way to do this. In order to sell bonds themselves you need to be able to borrow them, something only institutions can do. The spread betting companies all offer a similar service, making their money by charging their customers a wider spread than on the underlying contract, against which they can lay off their positions.

Typically a spread of three or four basis points is charged, when the contract itself will usually be quoted on a one basis point spread. (A basis point is one hundredth of one per cent, and nowadays in the UK and Europe is the same as a ‘tick’ which is the minimum amount a financial instrument can move. Fractions measured in thirty-seconds are still

preferred in the USA).

In return for their extra spread, the companies offer clients the convenience of internet dealing, plus the ability to trade in small size, typically stipulating a minimum tick value of half of that on the contract. IG Index allows clients to deal in sizes as small as £2 per tick. The gilt contract is itself £100,000 in size, so the tick value, or one-hundredth of one per cent, is £10. Moves of one point (100 basis points) are quickly and easily achieved in the gilt market, and would produce and profit or gain of £1,000 (£10 x 100) on the contract itself, so the smaller size is welcome to many.

The difference between spread betting and Contracts for Difference (CFDs) on the futures is not great, although because spread betting does not attract capital gains tax, most in the UK will show a natural bias towards it.

Mechanics of futures

Bond futures are based on a notional bond, in the case of the gilt paying a 6% coupon. Towards the expiry of the contract, which occurs in March, June, September and December, during the notice period the seller is obliged to deliver, upon demand of the buyer, cash bonds to the value of the contract. In the case of the gilt the deliverable bonds have a maturity of between 8.75 and 13 years. A conversion factor is applied to the future’s price to allow for the notional 6% coupon on the future and this gives the price at which the bond is delivered.

A couple of important points derive from the delivery of the underlying cash bonds upon the expiry of the contract. In order to avoid the difficulty and inconvenience of physical delivery private traders and most professionals will want to close out the position before the notice period, or do the ‘roll’ whereby the position in the near month is closed and and a new position opened in the next contract. This is carried out automatically, free of charge by the spread betting companies. CMC carries out the roll at a spread which is based on the average of 30-second readings taken during the day when CMC moves from the front to the further contract. IG Index uses the official closing prices on the day before it carries out the roll. Both means are transparent and fair but the spread between the two contracts is a constantly moving target. Depending on whether you are long or short it therefore may be a few ticks away from the best one for you.

One other little-appreciated detail about the way futures work and the underlying basket is that while the long gilt may be roughly seen as a ten-year, its actual behaviour will be more in tune with whichever bond is the cheapest to deliver in the basket of deliverables.

This can vary over the life of the contract.

Most of the spread betting companies offer a minimum of trading in the gilt and bund future, and the main long US contracts are designed around the ten-year note and the thirty-year bond. Some also offer the Schatz (German two-year) and Bobl (five-year), and two- and five-year note in the US. The Japanese Government Bond future (JGB) is also offered by a couple of firms, though interest in this will be limited by the time difference with Japan. The German bund itself is the leading contract in Europe’s leading market. It is more liquid than the UK gilt and has the advantage against American instruments of being in roughly the same time zone for UK-based players.

As always with trading it is important to know what your exposure is. Bond markets can gap on market-moving news and stops may be difficult to execute.

How to buy paper

If you want to deal in bonds themselves you can use broking services to buy individual instruments. Gilts are relatively easy. They can be dealt in small size, and there is plenty of transparency, with the Debt Management Office’s website (www.dmo.gov.uk) being one good source of information. For non-government bonds or ‘credit’ the main limitation is a lack of accessible information available. This is primarily because they are not exchange-traded and the big trading banks have little interest in private investors. Minimum denominations are a further hurdle. They can be as low as £1,000, but may well be £10,000.

Some of the bond platforms allow investors to access a wide selection of corporate bonds, and provide a custody service, all for a flat fee. Barclays Stockbrokers and Self-Trade offer an impressive selection. Investors need to be aware the bid-offer spread quoted in the professional market can vary enormously. Liquidity tends to be a function of the size of an issue and how old it is, with the larger more recent issues providing the best trading.

As a rule of thumb anything with an issue size under £500 million will

quickly become illiquid and should be avoided. The private investor has not only to contend with the underlying market, which may be as wide as half a point, but also with the reluctance of market-makers to deal odd lots. Both Barclays and Self-Trade say they can tell investors what spread they are paying before dealing.

ETFs – a new angle

Exchange Traded Funds (ETFs) are a new and alternative way to go long of credit. iShares offers ETFs on the UK gilt markets and also has four corporate bond ETFs based on iBoxx indices. The indices are based on a basket of bonds to which a group of market-makers provide price feeds. Amongst the four is a Sterling Corporate Bond ETF (SLXX), made up of 46 individual issues. These instruments have seen limited retail take-up so far, partly owing the lack of visibility for the underlying paper, at least for those not sitting on a trading floor.

Those wishing to access the attractions of non-government paper from an investment rather than a trading point of view are in any case almost certainly better off finding a well-run bond fund and allowing the managers to take care of the problems of dealing spreads and credit downgrades.