In preparation for resuming our exploration of hedge fund trading strategies, we took a detour last time out to learn about bond futures and conversion factors, which are used in basis trading. Basis trading is a form of fixed-income arbitrage that seeks to benefit from a change in the spread between a spot bond price and an adjusted futures price. The formula for the basis is:
B = SP – (FP x CF)
B is basis
SP is spot price of bond (clean)
FP is futures contract price (clean)
CF is conversion factor
Clean prices are ones in which the present value of future cash flows, such as interest payments, are not included in the price. Normally, one purchases a bond at the dirty price, which includes such cash flows.
A bond basis trade is the simultaneous purchase and sale of a bond and a bond futures contract to capture a non-zero basis as profit. It is also known as a cash-and-carry trade. (There is an alternative method of achieving the same result using exchange of futures for physicals (EFP) which we’ll not discuss in this article).
The conversion factor is the key to a basis trade. Here’s how it works:
- If the basis is negative, the bond spot price is less than the adjusted futures price. In this case, you would “buy the basis” by buying cash bonds and selling futures contracts. Say that the conversion factor on the 8 ¾ T-Bonds of 5/15/2017 is equal to 1.077. To buy $100M of the basis, you purchase $100M face value of the bonds and simultaneously sell 1,077 (= $100M * (1.077 / $100K) of bond futures.
- If the basis is positive, the bond spot price is greater than the adjusted futures price. Here you would “sell the basis” by selling cash bonds and buying futures contracts. For instance, if the conversion factor on the 7 5/8 T-Bonds of 2/15/2005 equals .0960, then selling $10M of the basis would require selling $10M face of the bonds and buying 96 futures contracts.
To close out the trade, you need to purchase your short position and sell your long position. If you compare the opening spread with the closing one, the difference is the change in basis during the holding period. A narrowing spread favors the short position; a widening spread benefits the long.
If you think the spreads will narrow over time, you benefit from selling the expensive bonds and buying the cheap futures contracts if your prediction is correct. The change in basis over time is the cash part of the trade. The carry portion consists of coupon payments less financing costs (at the repo rate) for the bond (including accrued interest). You realize a profit if the sum of the cash and carry portions are positive.
Every 1/32 of a basis point is worth $31.25; on a position of $10M face, this equals $3,125. Therefore, if a basis narrows by 2.6 basis points, the short position profits on the cash portion of the $10M face trade by 2.6 * $3,125 = $8,125. As long as the short’s carry costs do not exceed $8,125, he/she will pocket a profit.
The risk in a basis trade is that the basis will move in an unfriendly direction due to a change in the yield curve, and/or the repo rate will change to your disadvantage. These changes are important because of the following reasons:
1) If the repo rate decreases, or if the yield curve steepens, carry and basis increases
2) A decrease in the bond’s yield relative to other deliverable bonds will increase the basis
3) Bond duration can affect a bonds response to yield changes: the basis of a low-duration bond will tend to rise with bond yields, whereas the basis of a high-duration bond increases when bond yields fall.
4) Volatility affects technical considerations involving the short’s strategic delivery options. A rise in volatility would tend to lower the futures price and raise bond basis.
There is extensive literature on basis trading, and interesting parties are urged to seek it out before embarking on any trading activity.
Our next topic will be asset swap trades.