Bond markets in practice · RiskAtoms Academy

By the end you will be able to

1Describe how government bonds are sold at auction, traded through dealers, financed with repo, and how liquid they are.
2Calculate the cash raised and the interest paid when a bond position is financed with repo.
3Explain how bonds trade over the counter, and what the bid-ask spread tells you.
4Describe bond market liquidity and two stress episodes: March 2020 and the UK LDI crisis of 2022.

Why it matters

In March 2020, as COVID-19 spread, even US Treasuries, the deepest bond market in the world, became hard to sell. Investors wanted cash, dealers ran out of room, and the Federal Reserve had to step in. How do bond markets work on a normal day, and how can they seize up?

Core explanation

From auction to trading desk to repo

Issuing: auctions and syndications

Governments sell most new bonds at auctions. The debt office (the US Treasury, the UK Debt Management Office, Germany's Finance Agency) announces how much it will sell. Bidders say how much they want and at what yield. The office accepts the lowest yields first, which are the highest prices, until the amount is sold. The last yield accepted is the stop-out yield.

A core group of banks, the primary dealers (called gilt-edged market makers in the UK), commit to bid at every auction and to quote prices afterwards. Some bonds, especially long ones, are sold by syndication instead: a group of banks builds a book of orders from investors and the price is set to fill it.

Auctions come in two formats. In a single-price auction, the US Treasury's format, every winner pays the stop-out yield. In a multiple-price auction, used for conventional gilts, each winner pays its own bid. The bid-to-cover ratio shows how much demand there was.

Run itA 10-year government bond auction

Amount on offer3.00bn

Auction format

Bidder	Bid yield	Amount	Allotted	Pays yield
Dealer A	4.10%	0.80bn	?	–
Dealer B	4.12%	1.00bn	?	–
Pension fund C	4.13%	0.70bn	?	–
Dealer D	4.15%	1.20bn	?	–
Hedge fund E	4.18%	0.90bn	?	–
Dealer F	4.20%	0.60bn	?	–

Trading: dealers and screens

After issue, almost all bonds trade over the counter (L1.1.04). An investor asks one or more dealers for a price, or uses an electronic platform where several dealers compete. The dealer quotes two prices: the bid, at which it buys, and the ask, at which it sells. The bid-ask spread is the dealer's pay for taking the bond onto its books.

A quote of 99.50 / 99.53 means a round trip, buying and selling straight away, costs 0.03 per 100: £3,000 on £10m of bonds. In a calm government bond market that is normal; for a small corporate bond the spread can be many times wider.

Financing: repo

Dealers and hedge funds rarely pay for bonds with their own money. They use repo (L1.6.04): sell the bond to a lender today with an agreement to buy it back later at a slightly higher price. The difference is the interest. The lender hands over a little less cash than the bond is worth: the gap is the haircut, which protects the lender if the bond's price falls.

Repo is the plumbing of the bond market. It lets dealers hold inventory and lets investors take large positions with little capital. That same leverage is what turns a price fall into a scramble for cash.

Liquidity and stress

Liquidity (L1.1.07) is how quickly and cheaply you can trade without moving the price. Watch three things: the bid-ask spread, how much you can trade at that price (depth), and how far a trade of normal size moves the price. In calm markets government bonds score well on all three. In stress, all three can deteriorate at once. Step through two recent episodes:

Step throughTwo stress episodes

1 / 5

Mar 2020

The dash for cash

As the pandemic hit, investors around the world sold whatever they could to raise dollars, including US Treasuries. Funds that had bet on small gaps between Treasury and futures prices unwound their trades. Dealers' balance sheets filled up, bid-ask spreads widened, and prices jumped around.

Try it

Start with the worked example below: £10m of gilts, a 2% haircut, 5% for 30 days. Then raise the haircut to 10% and see how much more of your own money you need.

Try itRepo calculator

Open the money market model →

Market value of the bonds£10m

Haircut2.0%

Repo rate5.00%

Term (days)30

Market and day count

Cash raised today

£9,800,000

Own money needed£200,000

Repo interest£40,273.97

Buy back for£9,840,273.97

Position ÷ own money50.0×

The haircut is the lender's safety margin. The smaller it is, the more of the position is borrowed, and the bigger the losses relative to the investor's own money if prices fall.

Worked example

Financing a gilt position in repo

A hedge fund buys £10m (market value) of gilts and finances them in repo for 30 days. The haircut is 2% and the repo rate 5% a year. Sterling repo uses ACT/365. Try each step first.

Cash, interest and buy-back

Step 1 of 5

1
Cash lent against the gilts
$10{,}000{,}000 \times (1 - 0.02) = 9{,}800{,}000$

Regulatory lens

Government bonds are the core of banks' liquidity buffers: under the Basel liquidity coverage ratio they count as the highest-quality liquid assets (L4.5), on the assumption that they can be sold or repoed in stress. March 2020 tested that assumption.

Since then, the US Securities and Exchange Commission has adopted rules (December 2023) requiring many Treasury cash and repo trades to be centrally cleared, with compliance phased in over several years. In the UK, regulators set minimum resilience standards for LDI funds after 2022.

Sparks

SparkBid-to-cover is not the whole story

A high bid-to-cover ratio sounds like strong demand, but analysts watch the “tail” more closely: how far the stop-out yield lands above where the bond traded just before the auction. A big tail means the government had to pay up to sell its debt.

SparkThe plumbing is huge

Repo markets turn over trillions of dollars, euros and pounds every day. Most of it is overnight, rolled again and again. When repo stops working, almost everything else in the bond market stops too.

Key takeaways

Governments sell bonds mainly at auction, through primary dealers; some are sold by syndication.
In a single-price auction all winners get the stop-out yield; in a multiple-price auction each pays its own bid.
Bonds trade over the counter through dealers and electronic platforms. The bid-ask spread is the cost of trading.
Repo finances bond positions: cash = market value × (1 − haircut), interest = cash × rate × days ÷ year basis.
Liquidity can vanish in stress, as in March 2020 and the 2022 UK LDI crisis, and central banks may have to step in.

Reaction

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Glossary

Auction: A sale of new government bonds in which investors submit bids and the debt office accepts the best ones.
Primary dealer: A bank or broker-dealer appointed to bid at government bond auctions and make markets in the bonds.
Syndication: A sale of new bonds through a group of banks that gather orders from investors, instead of an auction.
Stop-out yield: The highest yield (lowest price) accepted in an auction.
Bid-to-cover ratio: Total bids divided by the amount on offer. A rough gauge of demand.
Over the counter (OTC): Over the counter: traded directly between two parties, usually through a dealer, not on an exchange.
Bid-ask spread: The gap between the price a dealer pays (bid) and the price it sells at (ask). A key measure of liquidity.
Repo: A sale of securities with an agreement to buy them back later at a set price. In effect, a loan secured on the securities.
Haircut: The amount by which the cash lent in a repo is less than the value of the securities, to protect the lender.
Market liquidity: How quickly and cheaply you can buy or sell without moving the price.

Deep Dives & Origins

Deep Dives

Bank of England, Financial Stability Report, December 2022 (the LDI episode). Intermediate.
Bank for International Settlements, BIS Bulletin and Quarterly Review articles on the March 2020 US Treasury market turmoil. Advanced.

Origins

UK Debt Management Office, gilt auction and syndication procedures (operational notice).
US Department of the Treasury, TreasuryDirect: how Treasury auctions work.
Bank of England, Financial Stability Report, December 2022.
US Securities and Exchange Commission, final rule on Treasury clearing (Standards for Covered Clearing Agencies for U.S. Treasury Securities), December 2023.

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