Bond Expert needed...

Discussion in 'Trading' started by trade-ya1, Feb 6, 2004.

  1. I was recently posed the following question and am thinking about retorting with the following answer. However, I really don't know what the f* I'm talking about. Can someone either answer this question or let me know if my answer makes any sense at all? I would greatly appreciate the help. Thanks!

    The following question was posed to me:

    Q: 'We would like to know what the relationship is between a bond portfolio (say consisting of long term US Government Bonds) and the 30-Year Treasury Bond Futures Contract traded on the CBOT. Although it would make sense that these two markets are strongly correlated, the relationship is not obvious. For instance, the USZ3 Futures contract (30 Y Treasury Bond December) has been quite volatile last month with swings of up to +/- 6% in price level. During this same time, most of the bond funds investing in long term US Government bonds have exhibited much less voltility and very often with weak correlation on a day to day basis. We are trying to understand the exact relationship between these two markets and how would one go about using the USZ3 futures contract to hedge a bond portfolio? On a broader scope, we would also be interested to see the most suitable way to use interest rate futures to hedge a bond portfolio. Any explainations, articles, books or comments would be helpful.'

    My answer is as follows:

    First of all, since the December contract has expired, I will discuss the issue with respect to the March futures contract. The March future trades in accordance with the 'Cheapest-to-deliver' which is the 6 7/8 Coupon expiring in 8/15/25. This Bond has a duration of 11.9 years. However, the on-the-run (active 30 year) is the 5 3/8 of 2/15/31 which has a duration of 14.1 years. As such, the difference in duration plus the yield curve effects probably explains much of the variation in returns. There is also some convexity issues whereas the Bond Future is negatively convex and the cash bond is positively convex. Furthermore, the Government has stopped the issuance of long-term 30 year Securities and as such, the more active futures contract is the Ten Year Note Future (TYH4). Due to the less active trading of the USH4 (illiquidity) it is subject to more volatile swings than the cash bonds. Nonetheless, to more effectively answer this question, one would need to know the average duration of the bonds being held by the Bond Funds. As far as a reference, the definative book is the Treasury Bond Basis Revised Edition, By Burghardt and Belton. However, you can also contact the CBOT Marketing Division (312-435-3500 general number) for some hedging info.
  2. Pabst


    trade-ya1: You're completely on target with but a couple of exceptions. The bond contract is not a 30 year but instead has the deliverable aspects of a hypothetical 20 year. Also, uniquely to other contracts mimicking the yield curve, the Bond future is far more liquid than it's corresponding cash market. Even in it's diminished capacity ZB trades about the same notional volume as ES on any given day.
    As you mentioned, the lack of new issuance in the long bond coupled with the preponderance of stripped zero's in the existing supply make the contract the easiest tradable vehicle. The contract has value as an instrument for duration extension and as a proxy for the hedging of long dated corporate's.

    I agree that few funds are true "T-bond" funds. Just not enough bonds out there. Most funds are closer to a 10 year than to ZB. Unless of course they hold zero's to add duration. Many funds however are sellers of option premium as a yield enhancement play. Being short options against portfolio naturally decreases a funds gamma i.e. volatility.
  3. Thank you very much for your kind reply!
  4. Pabst


    No sweat. IMO you're a cool guy.:)