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This article will cover the basics of trading bond spreads, specifically the 10-30 spread. The article will attempt to give you some background on how bonds are priced and the calculations that go into determining proper spread ratios.
The yield curve is a curve showing several yields or interest rates across different contract lengths for a similar debt contract. The curve shows the relation between the interest rate and the time to maturity, known as the “term”, of the debt for a given borrower in a given currency.
For example, the U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one above which is informally called “the yield curve.”
Both investors and traders can benefit by watching the yield curve changes, it may just signal your next trade.
Price and Yield
DV01 is a bond valuation calculation showing the dollar value of a one basis point decrease in interest rates. It shows the change in a bond’s price compared to a change in the bond’s yield.
A common misconception is that the DV01 of a Treasury security remains fixed as the yield of the instrument changes. In truth, the price-yield relationship of a Treasury security is nonlinear. As yields fluctuate, the DV01 of a Treasury security changes.
Exhibit 1 shows the price-yield relationship of a Treasury security as depicted by the curved line. As yields increase, a Treasury security’s price falls by decreasing dollar amounts. As yields decrease, a Treasury security’s price rises by increasing dollar amounts.
The line tangent to the curve represents the DV01 of a Treasury security. As yields increase, the slope of this line flattens. As yields decrease, the slope of this line steepens. This flattening and steepening of the line tangent to the curve illustrates the changing nature of a DV01 and is called convexity. The more dramatic the convexity, the more a DV01 will vary as interest rates fluctuate.
IMPORTANT: DV01 is the dollar value of a one basis point change in yield in the current Cheapest-to-Deliver (CTD) security
How to Calculate DV01
If you wanted to trade bonds versus each other you would need to either calculate DV01 yourself of find a site the publishes it, that way you can keep correct ratios to benefit the most form yield curve changes.
Price Sensitivity Method
The simplest way to calculate a DV01 is by averaging the absolute price changes of a Treasury security for a one-basis point (bp) increase and decrease in yield-to-maturity. This calculation will measure how much a Treasury security’s price will change in response to a one-bp change in the security’s yield.
[(∆ absolute Value with +1 bp) + (∆ absolute Value with -1 bp)] / 2 = DV01
Modified Duration Method
Another way to calculate the DV01 of a Treasury security is to use the security’s modified duration. Modified duration is simply a measure of the weighted average maturity of a Treasury security’s cash flows. As yields fall, modified duration increases. As yields rise, modified duration decreases.
A higher modified duration implies that a security is more interest rate sensitive. Conversely, a lower modified duration implies that a security is less sensitive. Modified duration assumes no convexity, but for small changes in yield it’s an effective measure of interest rate sensitivity that can be used to manage interest rate risk.
[(.01 X Modified Duration) X Price] X .01 = DV01
Calculating Futures DV01
Futures DV01 = Cash DV01 / Conversion Factor
The CME Group website provides all the information you need to construct a trade for the NOB Spread.
DV01 values are also published for you by the CME Group.
Conversion factors are published for you, or you can setup an excel sheet to do it for you.
The CME Group also publishes a ratio for all the interest rate products based on the current futures contract. These are rounded ratios and will be subject to shifts in the interest rate curve, so be aware.
Let’s get trading
Here is a simple trade on the 10-year note versus the 30 year bond .
The NOB Spread (10 versus 30)
The spread between the yields of the same security with differing maturities makes up the basis for this trade, plus the NOB spread is one of the most heavily traded yield curve spreads.
If you expect the yield curve to to steepen, you typically want to buy the spread.
If you expect the yield curve to flatten, you will want to sell the spread.
If a trader expects the yield curve to steepen, he can buy the 10-Year Treasury Note Future (ZN) and sell the 30-Year Treasury Bond Future (ZB). When the yield curve steepens, the 10-Year Treasury Note cash yield will fall relative to the 30-Year Treasury Bond cash yield, and the 10-Year Treasury Note futures price will rise relative to the 30-Year Treasury Bond futures price.
In this scenario, a long position in the 10-Year Treasury Note futures (ZN) will gain more than a short position in 30-Year Treasury Bond futures (ZB) will lose. Due to the inverse nature between price and yield in Treasuries, the yield spread will increase, but the price spread will decrease as with any bull spread. The converse is true, for a trader that is expecting the curve to flatten.
True yield curve spread filters out directional effects, changes due to parallel shifts in the yield curve, and responds only to changes in the slope of the yield curve or non-parallel shifts. This assumes you have the correct ratio of bonds relative to their duration and expected DV01.
The goal is to filter out directional effects and design a spread trade that will respond only to changes in the shape of the yield curve.
NOB Spreads are usually traded as ratio spread. This ratio matches the dollar value of a 1-bp change (DV01) in the yield of the shorter-term maturity futures position and that of the longer-term maturity futures position.
Trading the NOB Spread with 1:1 ratio
It is best to trade the NOB in the direction of the prevailing trend, buying weakness at or near support or selling strength at or near resistance. However, a mean reversion strategy can be utilized in a range market.
As of January 2013, for the next few years as long as interest rates are low, you should be able to trade the spread by buying any dips as rates start to creep up and the yield curve begins to steepen.
At ThinkOrSwim you will need to leg into each side of the spread. Some platforms support trading a constructed spread, in Interactive Brokers you can build this spread and trade it as a unit.
I use a 1:1 ratio when I trade the spread, this let’s me trade directionally with the /ZB, you won’t get margin benefit from this and you are marginally exposed to parallel changes in the yield curve. This trade is a long yields / short bond prices.
In other words, buy 1 /ZN and then sell 1 /ZB, so that is 2 trades in total. Exiting is the same process but in reverse. You can choose the front month or make a trade thesis based on farther out months.
A daily chart can be used to identify the prevailing trend, and a 15 minute chart is good for execution.
The chart below is a weekly chart of /ZN-/ZB since 2005. You can see the effect of the Federal Reserve flattening the yield curve since the financial crisis. This is the NOB Spread or 10-Year Note over 30-Year Bond Spread charted as price of a 10-year note versus a 30-year bond.
1 /ZN futures contract equals one U.S. Treasury note having a face value at maturity of $100,000.
1 /ZB futures contract equals one U.S. Treasury bond having a face value at maturity of $100,000.
However a 1:1 ratio does not hedge ZN-ZB due to varying DV01 and maturity of the deliverables.
Below is the spread when I initially wrote this article. The second chart is the spread approximately 5 months later.
Types of Spreads Other than The NOB using changes in the Yield Curve
These definitions apply to the NOB spread terminology as well, but you can use them to spread more than just the 10-year versus the 30-year. The 2-year versus the 5-year and the 2 year versus the 10-year can be exciting trades.
The Flattener trade takes advantage of the spread between yields on short term and long term bonds getting smaller, hence the yield curve is seen as ‘flattening’. The Steepener trade takes advantage of the spread on short term versus long term bond yields getting wider, hence the yield curve is getting steeper. The bull and bear naming convention comes from what the changes in the yield curve mean to the markets and the economy when pronounced on either the short term end or the long term end of the curve.
Below are examples of yield curve changes and their potential ramifications for the markets and the economy.
For the examples I just used the dates from my yield curve spreadsheet and made up my own rate changes. The blue (1/2/2013) represents the starting point, and the red (4/5/2013) represents the end yield curve.
Bull Flattener: When the shape of the yield curve flattens as a result of long term interest rates falling faster than short term interest rates. This can often happen because of a flight to safety trade and/or a lowering of inflation expectations. It is called a bull flattener because this change in the yield curve often precedes the Fed lowering short term interest rates, which is bullish for both the economy and the stock market.
Bear Flattener: When short term interest rates rise faster than long term interest rates. It is called a bear flattener because this change in the yield curve often precedes the Fed raising short term interest rates, which is bearish for both the economy and the stock market.
Bull Steepener: When short term interest rates fall faster than long term interest rates. This often happens when the Fed is expected to lower interest rates, a bullish sign for both the economy and stocks.
Bear Steepener: When long term interest rates rise faster than short term interest rates. This often happens when inflation expectations pick up, at which point the market may anticipate a fed rate increase to battle upcoming inflation. This scenario would be be bearish for both the economy and stock market.
When I asked you what Steepener I showed above, the real Yield Curve has done a Bear Steepener, in my opinion, as mid to long term rates have risen while short term rates have stayed low. Relative changes may tell a different story.
I think there will be opportunity for a Bear Flattener trade in the future. What do you think?
Some of the more popular ways to trade short term interest rate changes is to use a combination of the 2-year, the 5-year, and the 10-year Treasuries. Here is a paper from the CME Group that details a trade thesis and execution.
There is a great deal more to learn if you chose to trade interest rate spreads. This article should have given you the basics you need and you can study further from here.
Even if you choose not to trade interest rates and spreads, you should keep an eye on them as they may give you an early warning of market weakness or strength.
The CME Group provides many tools to assist you in trading interest rate and bond spreads.
Treasury Futures Empirical Duration Tool
U.S. Treasury futures trade in price, but it is often useful to consider strategies in terms of yield changes, taking into account the price sensitivity of the underlying security. This Empirical Duration Tool provides a convenient way to estimate a Treasury futures price for a given change in yield. It answers the question, “If the yield were to move by X basis points, what will happen to the Treasury Futures price?”
This information is especially useful in developing options strategies, for example, in determining which strike price to choose, assuming the yield move by a given amount.
Pace of the Roll
The Treasury futures roll represents the shift in open interest from the expiring front month quarterly futures contract to the deferred quarterly futures contract (e.g., from the September futures expiry to the December futures expiry). During the roll, market participants offset existing market positions in the front month contract while reestablishing new positions in the deferred month contract.
The Treasury futures roll occurs on a quarterly basis that coincides with the March, June, September, and December delivery cycle of the Treasury futures contracts.
Historically, the roll has occurred over a two-week period that is centered on the first delivery day of the expiring front month futures contract.
For 2-Year, 3-Year, and 5-Year Note futures, the roll typically begins 16 to 28 trading days prior to the last trading day in the expiring front month futures contract. The last trading day for the expiring front month 2-Year, 3-Year, and 5-Year Note futures contracts occurs on the last business day of the expiration month.
For 10-Year Note (ZN) and 30-Year Bond futures (ZB), the roll usually begins 12 to 16 trading days prior to the last trading day in the expiring front month futures contract. The last trading day for the expiring front month 10-Year Note and Bond futures contracts occurs on the seventh to last business day of the expiration month.
CME Group: DV01