Bond futures are financial derivatives that obligate the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond futures contract trades on a futures exchange market and is bought or sold through a brokerage firm that offers futures trading. The contract’s terms (price and expiration date) are decided when the future is purchased or sold.
Key Takeaways
- Bond futures are contracts that entitle the contract holder to purchase a bond on a specified date at a price determined today.
- A bond futures contract trades on a futures exchange and is bought and sold through a brokerage firm that offers futures trading.
- Bond futures are used by speculators to bet on the price of a bond or by hedgers to protect bond holdings.
- Bond futures are indirectly used to trade or hedge interest rate moves.
Understanding the Craft of Bond Futures
A futures contract is an agreement entered into by two parties. One party agrees to buy, and the other agrees to sell an underlying asset at a predetermined price on a specified date. On the futures contract’s settlement date, the seller must deliver the asset to the buyer. A futures contract’s underlying asset could 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 or Treasury bond.
A bond futures contract can be held until maturity, and it can also be closed out before the maturity date. If the party that established the position closes out before maturity, the closing trade will result in a profit or a loss from the position, depending on the value of the futures contract at the time.
Bond futures are standardized by the futures exchanges and are considered among the most liquid financial products. A liquid market means that there are plenty of buyers and sellers, allowing for the free flow of trades without delays. As such, the bond futures contract is used for hedging, speculating, or arbitrage purposes:
Essential Hedge and Speculation Tactics with Bond Futures
- Hedging is an investing strategy designed to protect holdings.
- Arbitrage is a strategy that takes advantage of an imbalance in prices. Traders try to profit from purchasing an asset or security on one exchange or venue and sell it on another.
- Speculating is investing in products that have a high-risk, high-reward profile. 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.
Efficient Strategies for Bond Futures Delivery
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 with a specific coupon or interest rate.
Futures traders typically close positions well before the chances of delivery. In fact, many futures brokers require that their customers offset positions (or roll to later months) well before the futures expiration.
Navigating the World of Bond Futures and Margin
Many futures contracts require margin, meaning a trader needs to deposit and maintain a specific amount in their brokerage account. This amount is generally much smaller than the notional value of the futures contract, and it must be deposited when a futures position is opened.
A broker requires an initial margin and a maintenance margin. Should the bond futures position decline sufficiently in value, the broker might issue a margin call, which is a demand for additional funds to be deposited.
Futures margin differs from securities margin. In futures trading, margin is the amount that must be maintained in the account. It does not fund your purchase, and it does not create a leveraged position. It is based on the underlying asset’s price and is used as a bond to ensure both parties can meet their obligations at expiry.
Understanding Bond Futures Risks and Opportunities
The risk of 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.
Primary Markets to Explore Bond Futures
Bond futures trade primarily on the Chicago Board of Trade (CBOT), which is part of the Chicago Mercantile Exchange (CME) Group. Contracts typically expire quarterly: March, June, September, and December. Examples of underlying assets for bond futures include:
- 13-week Treasury bills (T-bills)
- 2-, 3-, 5-, and 10-year Treasury notes (T-notes)
- Classic and Ultra Treasury bonds (T-bonds)
Many brokers offer bond futures, such as Charles Schwab/TD Ameritrade, Interactive Brokers, and TradeStation.
Pragmatic Techniques for 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—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, assume 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, the long trader’s account will be marked to a profit, and the short account will be debited.
Bond futures are overseen by the Commodity Futures Trading Commission (CFTC). The role of the CFTC includes ensuring that fair trading practices, equality, and consistency exist in the markets, as well as preventing fraud.
Conversion Factors in Bond Futures Market
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 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.
Defining Bond Futures: In Layman’s Terms
A bond future is a contract between two traders to buy and sell a bond at a specified price and date. Futures are used to speculate on a bond’s future price.
Demystifying Future Bond Rates
Future bonds rates change frequently. For instance, on Feb. 20, 2024, U.S Treasury Bond Futures yield was 4.46%.
Unraveling Interest Rate Futures and Bond Futures
Interest rate futures are contracts that have an underlying interest-bearing asset.Bond futures are examples of interest rate futures.
Conclusion: Embrace the Power of Bond Futures for Financial Prosperity
Bond futures obligate the contract holder to either buy or sell a bond at a predetermined price on a specific date. Bond futures traders try to profit from price changes in the short term and usually do not hold the contracts until expiry to avoid being forced to accept delivery.
There are benefits and drawbacks to futures trading—the consistently fluctuating market can significantly increase profits, but it also puts traders at higher risk.
Embark on your financial journey equipped with the knowledge of bond futures, and leverage them to create balanced, promising portfolios.
Related Terms: futures contract, Government or Treasury bond, maturity, standardized trading, margin requirements, interest rate futures.
References
- Chicago Mercantile Exchange Group. “Margin: Know What’s Needed”.
- Chicago Mercantile Exchange Group. “Understanding Treasury Futures”, Pages 1-17.
- Commodity Futures Trading Commission. “Basics of Futures Trading”.
- Commodity Futures Trading Commission. “History of the CFTC”.
- USAGov. “U.S. Commodity Futures Trading Commission”.
- Chicago Mercantile Exchange Group. “Understanding Treasury Futures”, Pages 5 and 6.
- CME Group. “U.S. Treasury Bond Futures and Options”.
