I know nothing about trading bonds. Can anyone tell me if it would feasible to trade the spread between the two year, five year, and ten year treasury notes/bonds (I don't even remember what the difference is). I have noticed that the spread between the different terms seems to vary a little bit. Could these be traded as "pairs"? If any of you are familiar with this market, I hope you will forgive my ignorance and enlighten me a little bit. If this is a feasible strategy, what are the best instruments to use, and what type of broker would you use. Thanks for any help.
If you are refering to buying the bonds and selling the notes or vise versa, of course you can. The bonds will often times have a larger move than the notes and the 10 will generally be larger than the 5's. So yes you can, and it will help with the risk by doing so. Make 'em pretty, Chris
What you are referring to is the yield curve. It is helpful to have a fundamental understanding of what makes the curve move. If the curve is flattening, you should buy long dated treasuries and sell near dated ones, vice versa if the curve is steepening. If we are in a strong economy (interest rates going up), expect the curve to flatten. If there is a flight to quality, or decrease in foreign bond buying, expect it to steepen. Chris is right regarding volatility, to set up a true spread you need to trade them in ratios to remove the directional element. For a 5yr/30 yr spread, you need to do a 2:1 ratio (approx). For a 5/10 a 3:2. You can work this out by doing a daily dollar volatility study. In my opinion, if you simply fade the spread when it gets "out of line" you will get hammered. Significant fundamental news can cause the curve to trend strongly. Best way to trade is using the notes/bonds on A/C/E, or the bunds/bobl/schatz on Eurex. An electronic broker with low commissions is necessary. Interactive brokers are no good as they don't offer spread margins for curve trades.
Thanks zentrader for your informative post. I have a question about the ratios. As a stock pair trader I sometimes trade pairs on a dollar equal basis wherein is xyz is $50 and abc is $25 I would put it on a 2:1 ratio if I expect one to under/over perfom other on a % basis BUT sometimes I am making a decision on the trend direction basis price so I put them on 1-1. If I put on the 5/10 FYT spread 1-1 I am not only speculating on the yield curvature but also the intrest rate direction. Since if int rates rise the $ spread narrows -am I right?
Your other comment about getting hammered when fading spreads would make me tend to believe that it is better playing divergence from the mean rather than convergence when trading these curve spreads. Am I correct? Thanks a bunch again!
GAtrader, I also often build in a directional bias by adjusting the ratios a little. I can then set up scenarios so if I am wrong I can get out for a smaller loss than if I am right, often I even make money when I call the outright move wrong. My comment regarding fading was more to do with putting on a convergence trade and sitting there waiting for it to come back. Although my studies have shown the curve has more trend than anti-trend to it. If you look at a long term chart it tends to be contained within a range, but trend from one extreme to the other. My general strategy is to wait for the spread to start getting a bit extreme, and then when some news comes in supporting a reversal, jump in then with the idea it will snap back over a few days.
Are there any leading indicators that bond tradersin CBOT and Eurex use to time their entry signals. Stock traders use TRIN, prem between SP and cash. I would assume the cash 5 /10 yr notes would be the indicator. I assume I have to subscribe to Bloomberg or reuters for it for the regular vendors like esignal won't have it. How about the bund/BOBL can you get quotes for the cash and is it a good entry signal? THanks
by Courtney Smith I have the book and it seems like a pretty good intro of spreads. However, he doesn't go specifically into yield curve spreads but does cover cost of carry spreads, correlation analysis etc. A whole chapter specifically on interest rate spreads, plus there is some info. on seasonal related spreads. Bone is the man for this type of trading info. BondTrader probably makes a good living too. I don't trade spreads but am trying to learn while I struggle to survive doing other types of trading.
Eldredge, You are talking about flattening / steepening of the yield curve. That's the core of bond trading. If you buy the bond and sell the note, that's a flattening trade because what you expect is the yield curve to become flatter one way or another (there are different possibilities). Steepening is the inverse (example: buy the 2yr sell the 5yr) Concerning the ratios, you need to study the concepts of duration and risk. Let's say duration of a 10yr bond is 8 and duration of a 5yr bond is 4: if you play this spread, your position should be twice bigger in the 5yr. This is really a complex subject (for example, for futures the 10yr note is not a real 10yr because the cheapest to deliver is maybe an 8yr bond). Reference author on this subject is Frank Fabozzi. The Handbook of Fixed Income Securities is the bible for bond traders.