What Are Bond Futures?
Bond futures are financial derivatives which obligate the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market, and the prices and dates are determined at the time the future is purchased.
- Bond futures are contracts that entitle the contract holder to purchase a bond on a specified date at a price determined today.
- A bond future can be bought on a futures exchange based on a variety of underlying bond instruments.
- Bond futures are used by speculators to bet on the price of a bond or else to hedge a bond portfolio.
- Bond futures indirectly are used to trade or hedge interest rate moves.
Bond Futures Explained
A futures contract is an agreement entered into by two counterparties. One party agrees to buy, and the other party agrees to sell an underlying asset at a predetermined price on a specified date in the future. On the settlement date of the futures contract, the seller is obligated to deliver the asset to the buyer. The underlying asset of a futures contract could either be a commodity or a financial instrument, such as a bond.
Bond futures are contractual agreements where the asset to be delivered is a government bond. Bond futures are standardized and liquid financial products that trade on an exchange. A liquid market is important since it means that there are plenty of buyers and sellers allowing for the free flow of trades without delays.
How Bond Futures Trade
The bond futures contract is used for hedging, speculating, or arbitrage purposes. Hedging is a form of investing in products that provide protection to holdings. Speculating is investing in products that have a high-risk, high-reward profile. Arbitrage can occur when there's an imbalance in prices, and traders attempt to make a profit through the simultaneous purchase and sale of an asset or security.
When two counterparties enter into a bond futures contract, they agree on a price where the party on the long side—the buyer—will purchase the bond from the seller who has the option of which bond to deliver and when in the delivery month to deliver the bond. For example, say a party is short—the seller—a 30-year Treasury bond, and must deliver the Treasury bond to the buyer at the date specified.
A bond futures contract can be held until maturity, and they can also be closed out before the maturity date. If the party that established the position closes out before maturity, it will result in a profit or a loss from the position.
Where Bond Futures Trade
Bond futures trade primarily on the Chicago Board of Trade (CBOT) or the Chicago Mercantile Exchange (CME). Contracts typically expire in March, June, September, and December, and the underlying assets include:
- 13-week Treasury bills (T-bills)
- 2-, 3-, 5-, and 10-year Treasury notes (T-notes)
- Classic and Ultra Treasury bonds (T-bonds)
Bond futures are overseen by a regulatory agency called the Commodity Futures Trading Commission (CFTC). The role of the CFTC includes ensuring that fair trading practices, equality, and consistency exists in the markets as well as preventing fraud.
Bond Futures Speculation
A bond futures contract allows a trader to speculate on a bond's price movement and lock in a price for a set future period. If a trader bought a bond futures contract and the bond's price rose and closed higher than the contract price at expiration, they would have profit. The trader could take delivery of the bond or offset the buy trade with a sell trade to unwind the position with the net difference between the prices being cash settled.
Conversely, a trader could sell a bond futures contract expecting the bond's price to decline by the expiration date. Again, an offsetting trade could be input at expiry, and the gain or loss could be net settled through the trader's account.
Bond futures have the potential to generate substantial profits since bond prices can fluctuate wildly over time due to varying factors. These factors include changing interest rates, market demand for bonds, and economic conditions. However, the price fluctuations in bond prices can be a double-edged sword where traders can lose a significant portion of their investment.
Bond Futures and Margin
Many futures contracts trade via margin meaning the funds are borrowed from a broker. An investor only needs to deposit a small percentage of the total value of the futures contract amount into the brokerage account. The futures markets typically use high leverage, meaning that the trader does not need to put up 100% of the contract amount when entering into a trade.
A broker might require an initial margin amount. The amount held by the broker can vary depending on the broker's policies, the type of bond, and the creditworthiness of the trader. However, should the bond futures position decline in value, the broker could issue a margin call, which is a demand for additional funds to be deposited. If the funds are not deposited, the broker can liquidate or unwind the position.
The risk to trading bond futures is potentially unlimited, for either the buyer or seller of the bond. Risks include the price of the underlying bond changing drastically between the exercise date and the initial agreement date. Also, the leverage used in margin trading can exacerbate the losses in bond futures trading.
Delivery with Bond Futures
As mentioned earlier, the seller of the bond futures can choose which bond to deliver to the buyer counterparty. The bonds that are typically delivered are called the cheapest to deliver (CTD) bonds, which are delivered on the last delivery date of the month. A CTD is the cheapest security that's allowed to satisfy the futures contract terms. The use of CTDs is common with trading Treasury bond futures since any Treasury bond can be used for delivery as long as it is within a specific maturity range and has a specific coupon or interest rate.
Bond Conversion Factors
The bonds that can be delivered are standardized through a system of conversion factors calculated according to the rules of the exchange. The conversion factor is used to equalize coupon and accrued interest differences of all delivery bonds. The accrued interest is the interest that's accumulated and yet to be paid.
If a contract specifies that a bond has a notional coupon of 6%, the conversion factor will be:
- Less than one for bonds with a coupon less than 6%
- Greater than one for bonds with a coupon higher than 6%
Before the trading of a contract happens, the exchange will announce the conversion factor for each bond. For example, a conversion factor of 0.8112 means that a bond is approximately valued at 81% of a 6% coupon security.
The price of bond futures can be calculated on the expiry date as:
- Price = (Bond Futures Price x Conversion Factor) + Accrued Interest
The product of the conversion factor and the futures price of the bond is the forward price available in the futures market.
Managing a Bond Futures Position
Each day, before expiration, the long (buy) and short (sell) positions in the traders’ accounts are marked to market (MTM), or adjusted to current rates. When interest rates rise, bond prices decline as the products sell off—since existing fixed-rate bonds are less attractive in a rising-rate environment. Conversely, if interest rates decrease, bond prices increase as investors rush to buy existing fixed-rate bonds with attractive rates.
For example, let's say a U.S. Treasury bond futures contract is entered into on Day One. If interest rates increase on Day Two, the value of the T-bond will decrease. The margin account of the long futures holder will be debited to reflect the loss. At the same time, the account of the short trader will be credited the profits from the price move. Conversely, if interest rates fall instead, bond prices will increase, and the long trader’s account will be marked to a profit, and the short account will be debited.
Traders can speculate on a bond's price movement for a future settlement date.
Bond prices can fluctuate significantly allowing the traders to earn significant profits.
Traders only have to put up a small percentage of the total futures contract's value at the onset.
The risk of significant losses exists due to margin and bond price fluctuations.
Traders are at risk of a margin call if the futures contract losses exceed the funds held on deposit with a broker.
Just as borrowing on margin can magnify gains, it can also exacerbate losses.
Real World Example of Bond Futures
A trader decides to buy a five-year Treasury bond futures contract that has a $100,000 face value meaning that the $100,000 will be paid at expiration. The investor buys on margin and deposits $10,000 in a brokerage account to facilitate the trade.
The T-bond's price is $99, which equates to a $990,000 futures position. Over the next few months, the economy improves, and interest rates begin to rise and push the value of the bond lower.
By expiration, the price of the T-bond is trading at $98 or $980,000. The trader has a loss of $10,000. The net difference is cash settled, meaning the original trade (the buy) and the sale are netted through the investor's brokerage account.