Understanding bond futures

Mark17

Member
I have never traded a bond future and am trying to better understand what I'm looking at.

A 20y chart of /ZT shows that on the last trading day of Nov 2020, I could buy a futures contract for 110 (and some ticks). If I held until this past Nov 30, which I'm guessing I could more or less do, I would have sold for 102 (and some ticks). It appears I would have lost around eight points.

In contrast, if I would have purchased at auction 2-year Treasury (Note) around the last trading day of Nov 2020 and held to maturity (around the end of Nov 2022, I'm guessing), I would have made money effectively through a return of principal plus positive interest.

There's a big difference between losing eight points and gaining 2-3%.

What am I not understanding?
 

DaveN

Member
I think there could be two things going on that might make this a head scratcher.

One is that if, for comparison sake, you purchased a fut contract in Nov 2020 at the time you bought the 2-year Note at auction, you'd have to keep rolling it over and suffer contract drag. That is the cost of rolling, or selling your low premium front contract and buying the higher premium next contract expiration. This drag or premium decay represents the cost of carry, or the opportunity cost of the money you'd put up to buy the actual 2 Yr Note, and I expect that's priced in. This drag or cost of rollovers should be relfected in the approximate equivalent duration ETF as well. That might be a good comparison. IEF is around a 10 year duration, and I don't remember offhand the 2 year ETF.

Also, consider that many charts will be based on adjusted-contracts, where a back adjusted will derate the price of previous contracts and vice versa for the front-adjusted. It's done so that indicators can work without the contract switchover discrepancies, but the pricing isn't very useful. That can throw things off when doing longer term comparisons.

I hope this doesn't miss the whole point of your question. I've traded the five's, ten's, and thirty's, but thought about them only as stand-alone instruments. My baseline assumption is that pricing is perfect, and those carry costs and drag are all factored in.
 

Mark17

Member
I think there could be two things going on that might make this a head scratcher.

One is that if, for comparison sake, you purchased a fut contract in Nov 2020 at the time you bought the 2-year Note at auction, you'd have to keep rolling it over and suffer contract drag. That is the cost of rolling, or selling your low premium front contract and buying the higher premium next contract expiration. This drag or premium decay represents the cost of carry, or the opportunity cost of the money you'd put up to buy the actual 2 Yr Note, and I expect that's priced in. This drag or cost of rollovers should be relfected in the approximate equivalent duration ETF as well. That might be a good comparison. IEF is around a 10 year duration, and I don't remember offhand the 2 year ETF.

Also, consider that many charts will be based on adjusted-contracts, where a back adjusted will derate the price of previous contracts and vice versa for the front-adjusted. It's done so that indicators can work without the contract switchover discrepancies, but the pricing isn't very useful. That can throw things off when doing longer term comparisons.

I hope this doesn't miss the whole point of your question. I've traded the five's, ten's, and thirty's, but thought about them only as stand-alone instruments. My baseline assumption is that pricing is perfect, and those carry costs and drag are all factored in.

I totally forgot about the continuous contract stuff when stitching together a futures chart. And what you say about drag totally makes sense. Do you know how I can view term structure on TOS?

Your point about drag only exacerbates my misunderstanding, though. If you were to buy that 2-year Treasury, in every instance you would make money after two years unless interest rates turned negative enough (and for a long enough period of time to affect coupon payments [assuming there were any? Bonds have them but T-bills don't]), which hasn't happened [I want to add "ever" here but I'm not absolutely certain). Looking at the [continuous contract] futures chart, though, it's clearly NOT mostly up... bring up a 20y monthly and you can see. Bonds themselves, though? Look at the bar chart here: https://bit.ly/3FZhGpw

Here's something else I find a bit puzzling. From this Investopedia page, https://www.investopedia.com/terms/b/bondfutures.asp , is this example:

> A trader decides to buy a five-year Treasury bond futures contract that has a $100,000 face value
> meaning that the $100,000 will be paid at expiration. The investor buys on margin and deposits $10,000
> in a brokerage account to facilitate the trade.
>
> The T-bond's price is $99, which equates to a $99,000 futures position. Over the next few months,
> the economy improves, and interest rates begin to rise and push the value of the bond lower...
>
> Assume at expiration, the price of the T-bond is trading at $98 or $98,000. The trader has a loss of
> $1,000. The net difference is cash-settled, meaning the original trade (the buy) and the sale are netted
> through the investor's brokerage account.

In thinking about futures as a possible proxy for owning the bond, this doesn't make sense because at maturity, the T-bond will always be priced at par value. Now if that is built into the futures contract than it all may end up making sense. I don't see that when looking at that 20y /ZT futures chart, but maybe it's because of the continuous contract calculations.

I called TDA to ask this and they said I would be forced to close at the first notice date... they don't deal with delivery and would never be able to hold until "maturity" of any sort. They also said there really is no maturity with regard to futures. The price at any point is the expected price if I were to enter into a position two years hence.
 

jim leahy

Active member
re: Mark17 What am I not understanding?

i think you're confusing bond interest and bond pricing. true, if you hold a
2year note to maturity you get all the principal back plus interest (assuming
the government doesn't default), but before maturity the note price will
fluctuate with interest rates. when interest rates rise, bond/note prices
fall. in november 2020, 2 year notes were paying .16% interest. by november
2022 they were paying 4.38% interest. consider buying a 2 year note for $1000
with .16% coupon and a year later you want to sell it, but 1 year interest
rates are 4.0%. no one will pay you $1000 for that note paying .16%, when
they can buy a newly issued note paying 4.0%. you will have to reduce the
price to a value such that your note would yield 4.00% at maturity.

besides the problem with the rolling the futures contract and the continuous
pricing in the charts, as described by DaveN, you have to consider the change
in rates. current 2 year note futures are priced around 102'186. (pricing is
difficult to interpret. this equates to 102 + 18/32nds + 3/128ths, i think).
Pricing for november 2020 would be a lot higher, so you definitely would have
lost money. it would likely be less than the 110 you quoted, due to the roll
adjustments, but definitely higher than a 2 year note today.

there's a parameter called DV01, which is the dollar value of a 1
basis point change in rates. one basis point is .01%. this value varies with
duration and rates. the attached slide is from a tastytrade presentation
in 2017. at that time 2 year rates were 1.28% so the dv01 for a 2 year note
now would be different. i don't remember if it would be higher or lower. you
can find the formula on he web.

trading treasury futures is a bet on future interest rates.
my understanding on bond pricing may not be correct, but this is what i remember
from a presentation a long time ago and other articles i found. the futures are
based on a constant maturity bond with a yield of 6%, priced at $100. so when
rates are lower than 6% the futures will be more than $100 based on the dv01.
this is why the current note is $102+. the delivery at expiration for a
position is a nominally 2 year note. there is a range of maturities by a
few months (referred to as cheapest to deliver), that can be delivered on
settlement. the price of that note will be discounted by some factor based
on its interest rate compared to 6%. only a small percentage of contracts are
settled in bond delivery, most are closed or rolled. bond math isn't easy.

remember, the 2 year note contract has a $200,000 notional value so a 1 point
move equals $2000. be sure you know your risks before diving in.

you can find historical interest rates at:


dv01a.png
 
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