Yield curve spreads – a little-known way to trade profitably

Bonds, The Opening Print, Trading Methods

If you can trade futures contracts you can trade the yield curve spread. If you trade futures and you are NOT trading the yield curve spread you are likely adding unnecessary risk to your portfolio.

Yield curve spreads diversify risk, have low correlation to other major asset classes and often act as a leading economic indicator.

Yield Curve Spreads and Large Cap Equity Performance Correlation:

The yield curve is generally thought to be a leading indicator of equity performance. The yield curve and its correlation to equity markets is an often researched and widely published topic. A Google search of “yield curve spread equity correlation” returns some 2.86 million results. The Federal Reserve Bank of New York, the FDIC and Duke University’s Fuqua School of Business are among the first page search results. The New York Fed has a web page titled “The Yield Curve as a Leading Indicator”.

The slope of the yield curve is heavily influenced by central bank monetary policy. The yield curve reflects current monetary policy, expected monetary policy actions and inflation expectations. Central banks raise and lower rates to reign in / stimulate the economy. A flat yield curve indicates tight monetary policy. Steep yield curves reflect periods of monetary stimulus. As a result the yield curve can be used as a leading indicator for major equity indices and yield curve spreads have low correlation to major equity indices.

The chart below shows the yield curve spread versus large cap equities:

yield-curve-spread-vs-large-cap-stocks

Yield curve spread trades defined

A yield curve spread is the yield differential between two different maturities of a bond issuer i.e. 10 yr U.S. Treasury yield – 5 yr U.S. Treasury yield. The later maturity leg of the trade is referred to as the back leg and the trade leg maturing earlier is called the front leg.
Two primary yield curve spread strategies are the “flattener” and the “steepener.”

The risk measure for yield curve spread trades is DV01 (dollar value of a basis point). As the back leg DV01 is greater than the front leg DV01, one must calculate a hedge ratio to result in a DV01 neutral position.

Yield curve spread trade performance characteristics

An attractive characteristic of yield curve spread trades is that performance is independent of absolute interest rate changes. As the transactions are long / short by definition, market rallies or sell-offs do not generally affect performance in the same way an outright long or short bond or futures position would be affected.

And, to repeat, performance is not tied to changes in absolute levels of rates, but rather changes in the yield differential between two rates. In a rising rate environment where rates increase from 1.75% to 5.00% and the yield curve steepens, a long NOB position will be profitable while your outright long competition is down! This is a critically important point – please take a minute and re-read this section.

Trade execution

“NOB” stands for “Note over Bond” and refers to a spread which takes advantage of relative changes between the 10-year Treasury Note and the 30-year Treasury Bond. Bond futures traders are familiar with these two instruments, but even many bond traders haven’t learned about trading the spread. Large institutions have been trading it for decades, but it hasn’t been possible for individual retail traders to do so until recently. That’s where Curve Trades gives you an edge.

So we have looked at the NOB yield curve spread over time, performed our analysis and estimated potential returns. How exactly do we execute the trade? There are three alternatives:

1. execute an order for the front leg and the back leg
2. execute a CME Group NOB spread order
3. combination of both.
The figure below is a screen shot of CurveTrades Trade Structuring Tool. The CurveTrades Trade Structuring Tool compares trade execution alternatives.

curve-trades-structuring-tool

As you can see, you can Sell 242 ZN (the December Note) and Buy 100 ZB (December Bond) or you can Sell 100 NOB (the CME spread instrument). While the CME Group resets the spread ratios quarterly, the NOB ratio is generally 2:1. Thus by selling 100 NOB spreads your resulting position is:

NOB Spread (assuming 2:1 ratio)
Sell 100 NOB

ZN (200)
ZB 100

There is a 42 contract mismatch between the DV01 neutral execution and the NOB order. This mismatch is called the tail. As seen above, an order placed to true up the tail can be combined with the NOB spread order to maintain a DV01 neutral position.
Please note the return estimations do not attempt to account for transaction fees, implied carry or any other costs. The example is purely hypothetical.

Unfortunately, curve trades have historically suffered from four problems:

  • Operational complexity
  • Lack of yield based data availability
  • Confusing market quotation methodology
  • An absence of widely available easy to use analytical tools.

So what would a solution look like, one that was not complex, had access to the right data, and was readily available to the public? It would look like what we offer at Curve Trades.

Cash vs. futures execution: pros and cons

Execution of a yield curve trade can be in either cash or futures markets. Transparent pricing is difficult because U.S. Treasury securities are not exchange traded. Furthermore, the short leg of a cash Treasury spread requires borrowing the underlying bond and paying accrued interest. The long leg requires buying accrued interest. These factors decrease capital efficiency. One then needs to roll both trade legs to stay in the on-the-run security. The result consumes capital and imposes operational burdens.

Futures, unlike Treasury securities bought with cash, are exchange traded and capital efficient. The CME Group and other exchanges explicitly recognize the reduced risk profile of a spread, and offer margin offsets for certain curve trades. Futures contracts do have a few idiosyncrasies; fortunately, tools are available that simplify the more complex aspects of executing a futures based yield curve spread trade. These resources enable the market to easily identify value, structure efficient trades and manage risk.

Conclusion

In the past, the accessibility for institutions and individuals to trade the yield curve spread has been unnecessarily opaque and complex. Much of the difficulty stems from the fact that U.S. Treasury securities are not exchange traded. Additionally, it is difficult to identify the cheapest-to-deliver security and even more difficult to determine the true implied cost basis in the CTD for a given futures price.

Fortunately, CurveTrades solved this problem via an economical intuitive web application that is available to all.

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