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.
Loyal readers know that we are currently surveying hedge fund strategies. As we pivot from equity strategies to fixed-income arbitrage, we will first take a short “time out” to learn about yield curves. In this article we’ll discuss yield curve shapes; next time out we will explore the theories that attempt to explain yield curve behavior.
Yield curves (also known as the term structure of interest rates) plot debt maturities (the independent variable) against interest rates (the dependent variable). Debt maturities indicate the length of the borrowing period for a debt instrument. The interest rate associated with a given borrowing period is a point on the yield curve. Curve segments between actual maturities are interpolated. Yield curves are specific for a given currency – the yield curves for U.S. dollar-denominated Treasury bonds will (almost always) differ from the analogous chart of U.K. pound-denominated gilts.
Debt yield is the overall rate of return on a debt instrument. Debt that is “locked up”, as in a certificate of deposit, will usually offer a higher yield than an on-demand savings account, due to the higher certainty of holding the former to maturity. Yield curves normally ascend with time, but the rate of increase diminishes with increased time. The fancy phrase for this is an asymptotically upward slope. It reflects the fact that it is riskier to hold longer maturities, because it’s harder to predict distant future interest rates than it is to predict near term interest rate. This increased uncertainty usually demands a risk premium, i.e. a higher interest rate (known as a liquidity spread). This makes the most sense if investors anticipate a period rising short-term interest rates – current investors willing to tie up their money today must be compensated for forgoing higher interest rates tomorrow. But even if rates are not forecast to rise, the liquidity spread tends to give longer maturities higher yields.
An inverted yield curve is, as you might suspect, one in which short term rates are higher than long term ones. Inverted curves indicate an anticipated drop in interest rates over time. This is not considered a good thing – inverted yield curves are often associated with strong recessions and depressions. Forecasts of a weak economy motivate long-term investors to agree to lower yields, on the premise that yields may go even lower. On the plus side, inverted yield curves indicate a belief in low future inflation. However, in an economic panic, a flight to quality may increase demand for, and thus lower the yield of, long-term government bonds.
Currency is a prime determinant of yield curve shape. Another determinant is the type of debt instrument: government bonds, bank debt, corporate bonds, and asset-backed securities. The latter three also vary by the creditworthiness of the issuer – debt with ratings of Aa/AA and above is less risky than lower-rated debt, and hence demands less of a premium over the interest rates for government debt. The London Interbank Offered Rate (LIBOR) is a benchmark rate reflecting the interest rates top London banks charge each other for unsecured funds. LIBOR is important in the swap market because it is used to peg the floating rate leg of an interest rate swap. For this reason, the LIBOR yield curve is often referred to as the swap curve.
As we noted, the normal yield curve has a positive slope, reflecting investor sentiment that economies will grow over time and that inflation rates will rise accordingly. Central banks, such as the U.S. Federal Reserve, control a country’s money supply in order to either keep a lid on inflation (by tightening the money supply, i.e. raising short term interest rates) or fight recession and deflation (by increasing liquidity and reserves in credit markets, i.e. lowering short term rates and/or printing more money).
Historically, the 20-year Treasury bond has yielded a spread of two additional interest rate points above the three month Treasury bill. However, events can cause yield curves to steepen (larger spreads) or flatten (smaller spreads). Recently, the spread between 2-year and 10-year Treasuries widened to record-setting amounts approaching 3%. Sometimes, a yield curve is bicameral, or humped, meaning that medium-term yields exceed long- and short-term ones. This can occur when short term volatility is expected to be more significant than that in the long term. Flat yield curves can predicts steady interest rates or reflect general uncertainty about the economic future.