Understanding US Treasury FuturesThirty-year Treasury bond futures were originally introduced on the Chicago Board of Trade in 1977.
The product line was augmented over the years by the introduction of 10-year, 5-year, 2-year Treasury
note and 30-year “Ultra” Treasury bond futures.
This product line has experienced tremendous success as the scale and global significance of U.S.
Treasury investment has grown over the years. Today, these products are utilized on an international basis by institutional and individual investors for purposes of both abating and assuming risk exposures
This report is intended to provide an overview of the fundamentals of trading U.S. Treasury bond
and note futures. We assume only a cursory knowledge of coupon bearing Treasury securities, providing a grounding in cash Treasury markets; some detail regarding the features of the U.S. Treasury futures contracts; and, a discussion of risk management applications with U.S. Treasury futures.
Coupon-Bearing Treasury Securities: US Treasury bonds and notes represent a loan to the U.S. government. Bondholders are creditors rather than equity- or shareholders. The U.S. government agrees to repay the face or principal or par amount of the security at maturity, plus coupon interest at semi-annual intervals. Treasury securities are often considered “riskless” investments given that the “full faith and credit” of the U.S. government backs these securities. The security buyer can either hold the bond or noteuntil maturity, at which time the face value becomes due; or, the bond or note may be sold in the secondary markets prior to maturity. In the latter case, the investor recovers the market value of the
bond or note, which may be more or less than its face value, depending upon prevailing yields. In the meantime, the investor receives semiannual coupon payments every 6 months.
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Price/Yield Relationship: A key factor governing the performance of bonds in the market is the
relationship of yield and price movement. In general, as yields increase, bond prices will decline;
as yields decline, prices rise. In a rising rate environment, bondholders will witness their principal
value erode; in a decline rate environment, the market value of their bonds will increase.
IF Yields Rise .. THEN Prices Fall .. IF Yields Fall .. THEN Prices Rise ..
This inverse relationship may be understood when one looks at the marketplace as a true auction.
Assume an investor purchases a 10-year note with a 6% coupon when yields are at 6%. Thus, the
investor pays 100% of the face or par value of the security.
Subsequently, rates rise to 7%. The investor decides to sell the original bond with the 6% yield, but no one will pay par as notes are now quoted at 7%. Now he must sell the bond at a discount to par in order to move the bond, i.e.,rising rates are accompanied by declining prices. Falling rates produce the reverse situation. If rates fall to 5%, our investment yields more than market rates. Now the seller can offer it at a premium to
par. Thus, declining rates are accompanied by rising prices. Should you hold the note until maturity, you
receive the par or face value. In the meantime, of course, one receives semi-annual coupon payments.
Quotation Practices: Unlike money market instruments (including bills and Eurodollars) that are
quoted on a yield basis in the cash market; coupon bearing securities are frequently quoted in percent
of par to the nearest 1/32nd of 1% of par. e.g., one may quote a bond or note at 118-20. This
equates to a value of 118% of par plus 20/32nds. The decimal equivalent of this value is 118.625. Thus, a million-dollar face value security might be priced at $1,186,250. If the price moves by 1/32nd from 118-20 to 118-21, this equates to a movement of $312.50 (per million-dollar face value).
The normal commercial “round-lot” in the cash markets is $1 million face value. Anything less might be considered an “odd-lot.” However, you can purchase Treasuries in units as small as $1,000 face
value. Of course, a dealer’s inclination to quote competitive prices may dissipate as size diminishes.
30-year Treasury bond, 10-year Treasury note and 5-year Treasury note futures, however, are traded in
units of $100,000 face value. 3-year and 2-year Treasury note futures are traded in units of $200,000 face value.
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Accrued Interest and Settlement Practices – In addition to paying the (negotiated) price of the coupon-bearing security, the buyer also typically compensates the seller for any interest accrued between the last semi-annual coupon payment date and the settlement date of the security. e.g., it is March 29, 2011. You purchase $1 million face value of the 3-5/8% Treasury security maturing in February 2021 (a ten-year note) for a price of 101-04 ($1,011,250) to yield 3.489%, for settlement on the next day, March 30, 2011.
In addition to the price of the security, you must further compensate the seller for interest of $4,305.94 accrued during the 43 days between February 15, 2011 (the issue date) and the settlement date of March 30th.
This interest is calculated relative to the 181 days between the issue date of February 15th and the
next coupon payment date of August 15th or $4,305.94 [= (43/181) x ($36,250/2)]. The total
purchase price is $1,015,555.94.
Typically, securities are transferred through the Fed wire system from the bank account of the seller to
of the buyer vs. cash payment. That is concluded on the settlement date which may be different from the
trasnaction date.
Unlike the futures market where trades are settled on the same day they are transacted, it is customary
to settle a cash transaction on the business day subsequent to the actual transaction. Thus, if you
purchase the security on a Thursday, you typically settle it on Friday. If purchased on a Friday,
settlement will generally be concluded on the following Monday.
Sometimes, however, a “skip date” settlement isspecified. For example, one may purchase a security on Monday for skip date settlement on Wednesday. Or, “skip-skip date” settlement on Thursday; “skip-skip-skip date” settlement on the Friday, etc. Theoretically, there is no effective limitation on the number of days over which one may defer settlement – thus, these cash securities may effectively be traded as a forward.
Treasury Auction Cycle – Treasury securities are auctioned on a regular basis by the U.S. Treasury
which accepts bids on a yield basis from security dealers. A certain amount of each auction is set aside, to be placed on a non-competitive basis at the average yield filled.
Prior to the actual issuance of specific Treasuries, they may be bought or sold on a “WI” or “When Issued” basis. When traded on a WI basis, bids and offers are quoted as a yield rather than as a price. After a security is auctioned and the results announced, the Treasury affixes a particular coupon to bonds and notes that is near prevailing yields. At that time, coupon bearing bonds and notes may be quoted on a price rather than a yield basis. However, bills continue to be quoted and traded on a yield basis. Trades previously concluded on a yield basis are settled against a price on the actual issue date of the security, calculated per standard price/yield formula.
Security dealers purchase these securities and subsequently market them to their customers including pension funds, insurance companies, banks, corporations and retail investors.
The most recently issued securities of a particular maturity are referred to as “on-the-run” securities. On-the-runs are typically the most liquid and actively traded of Treasury securities and, therefore, are often
referenced as pricing benchmarks. Less recently issued securities are known to as “off-the-run” securities and tend to be less liquid.
The Treasury currently issues 4-week, 13-week, 26- week and 52-week bills; 2-year, 3-year, 5-year, 7-year and 10-year notes; and, 30-year bonds on a regular schedule. In the past, the Treasury had also
issued securities with a 4-year and 20-year maturity. Further, the Treasury may issue very
short term cash management bills along with Treasury Inflation Protected Securities or “TIPS.”
The “Run” – If you were to ask a cash dealer for a quotation of “the run,” he would quote yields associated with the on-the-run securities from the current on-the-run Treasury bills, through notes, all
the way to the 30-year bond.
The most recently issued 30-year bond is sometimes referred to as the “long-bond” because it is the
longest maturity Treasury available. But the most recently issued security of any tenor may be
referred to as the “new” security. Thus, the second most recently issued security of a particular original
tenor may be referred to as the “old” security, the third most recently issued security is the “old-old”
security, the fourth most recently issued security is the “old-old-old” security.
As of March 29, 2011, the most recently issued 10-year note was identified as the 3-5/8% note maturing in February 2021; the old note was the 2-5/8% note of November 2020; the old-old note was the 2-5/8% of August 2020; the old-old-old note was the 3-1/2% of May 2020.
Beyond that, one is expected to identify the security of interest by coupon and maturity. For example,
“3-5/8s of ‘20” refers to the note with a coupon of 3-5/8% maturing on February 15, 2020. As of March 29, 2011, there were not any “WI” or “when issued” 10-year notes. Note, however, that WIs typically trade on a yield basis in anticipation of the establishment of the coupon subsequent to the original auction.
One important provision is whether or not the security is subject to call. A “callable” security is where the issuer has the option of redeeming the bond at a stated price, usually 100% of par,prior to maturity. If a bond is callable, it may be identified by its coupon, call and maturity date. I.e.,the 11-3/4% of November -14 is callable in November 2009 and matures in 2014.
Prior to the February 1986 auction, the U.S. Treasury typically issued 30-year bonds with a 25- year call feature. That practice was discontinued at that time, however, as the Treasury instituted its“Separate Trading of Registered Interest and Principal on Securities” or STRIPS program with respect to all newly issued 10-year notes and 30-year bonds. 4
The Roll and Liquidity: Clearly, traders who frequently buy and sell are interested in maintaining
positions in the most liquid securities possible. As such, they tend to prefer on-the-run as opposed to
off-the-run securities. It is intuitive that on-the-runs will offer superior liquidity when one considers the “life-cycle” of Treasury securities. Treasuries are auctioned, largely to broker-dealers, who subsequently attempt
to place the securities with their customers. Often these securities are purchased by investors who may
hold the security until maturity. At some point, securities are “put-away” in an investment portfolio
until their maturity. Or, they may become the subjects of a strip transaction per the STRIPS
program.
As these securities find a home, supplies may become scare. As a result, bid/offer spreads may inflate and the security becomes somewhat illiquid. Liquidity is a valuable commodity to many. Thus, you may notice that the price of on-the-runs tends to be bid up, resulting in reduced yields, relative to other similar maturity securities. This tends to be most noticeable with respect to the 30-year bond.
Paul A. Ebeling, Jnr. writes and publishes The Red Roadmaster’s Technical Report on the US Major Market Indices, a weekly, highly-regarded financial market letter, read by opinion makers, business leaders and organizations around the world.
Paul A. Ebeling, Jnr has studied the global financial and stock markets since 1984, following a successful business career that included investment banking, and market and business analysis. He is a specialist in equities/commodities, and an accomplished chart reader who advises technicians with regard to Major Indices Resistance/Support Levels.:idea:
