What Are Bond Futures?
Bond Futures is a contract that puts liability on the holder to purchase and sell a fixed amount of bonds as specified in the contract agreement at a price which is predetermined by the contract holder where the other side is the exchange. Hedgers and speculators use these to safeguard or protect their holdings.
Bond Futures can be bought and sold in the exchange market, the price and dates are standardized at the time when an agreement is entered into by the holder. These generally involve Treasury bonds or government bonds and are considered one of the most liquid financial products.
Table of contents
- Bond futures are financial contracts enabling investors to speculate on future price movements of government bonds or fixed-income securities, managing interest rate risk and potentially profiting from price changes.
- The value of bond futures is determined by the underlying bond’s price, yield, and maturity. The futures contract represents an agreement to buy or sell the bond at a predetermined price and future date.
- Bond futures serve multiple purposes, including hedging against interest rate fluctuations, speculating on interest rate movements, and gaining bond market exposure without physically holding the bonds.
How Do Bond Futures Work?
Bond futures are the most popular financial products that investors invest in. The delivery assets in this case are treasury or government bonds.
One of the important interest rate contracts is Treasury bondTreasury BondA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company. contracts traded in the United States. The party with the short positionShort PositionA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date. has a number of interesting delivery options:
- Delivery can be made any day during the delivery month.
- There are a number of alternative bonds that can be delivered.
- On the day of the delivery month, the notice of intention is to deliver at 2.00 pm, and the settlement price can be made any time up to 8.00 pm.
Calculating the price of the products is a crucial affair and there is a sequence of steps that is followed to learn how these are priced. Here is an instance that explains how these bond futures are priced:
CME bond futures have more than 15 years to maturity on the first day of the delivery month and is not callable within 15 years from that day can be delivered. The 10, 5, and 2-year Spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery. (S0)
- I – the present value of the coupons during the life of the futures contract
- T – is the time until the maturity futures contract
- r – is the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.
This contract is quoted in dollars and thirty seconds of dollars per $100 face value. This is similar to the way bonds and notes are quoted in the spot market. Let’s say the settlement price of this contract for June 2017 delivery is specified as 124-150. This means 124 (15/32) or 124. 46875. Taking the next example, if the settlement price of September 2017 is quoted as 120-105 means 120 (10.5/32) or 120.328125.
Suppose an investor enters into a treasury contract to deliver a bond @ 12 % coupon with a conversion factor of 1.6000 where the delivery will take place in 270 days. Coupons are payable semi-annually on the bond, and the last coupon date was 60 days ago, the next coupon date is in 122 days, the coupon date thereafter is in 305 days. The term structureTerm StructureThe term structure is the graphical representation that depicts the relationship between interest rates and various maturities. The graph itself is called a “yield curve.” The term structure of interest rates plays an essential part in any economy by predicting the future trajectory of rates. is flat, and the interest rate is 10% per Annum. Assume that the current quoted bond price is $115.
The cash price of the bond is obtained by adding the quoted priceQuoted PriceA quoted price refers to the latest trading (bid and ask) value agreed upon by traders for security. It usually appears as a notification on the online trading platforms, signifying prices of in-demand stocks, bonds, derivatives, or commodities. Exchanges express it in cents or dollars. the proportion of the next coupon payment that accrues to the holder.
= $115+(60/ (60+122)) * 6
A coupon of $6 will be received after 122 days (.3342 years). The present value of this
The future contract lasts for 270 days (0.7397). The cash future price, if the contract is written on a 12 % bond, would be
- = (116.978-5.803) e (0.1*.7397)
- = $119.711
There are 148 days of accrued interest from delivery. If the contract is written on a 12 % bond, accrued interest is excluded in order to calculate the quoted future price.
- = (119.711-6) + 148/(148+35)
- = $114.859
The quoted futures price is given below considering 1.6000 conversion factor equivalent to a 12% standard bonds
- = 114.859/1.6000
- = 71.79
How To Derive Cheapest Delivery?
The party with the short position or the writer of the bond chooses the bond that is cheapest to deliver among a wide variety of bonds. And his decision is based on the below derivation :
And the cost of purchasing the bond is,
The cheapest to deliver bond is one for which the below is the least.
The number of factors determines the cheapest to deliver the bond. If bond yieldsBond YieldsThe bond yield formula evaluates the returns from investment in a given bond. It is calculated as the percentage of the annual coupon payment to the bond price. The annual coupon payment is depicted by multiplying the bond's face value with the coupon rate. reach 6%, the conversion factor system enables the writer to deliver long maturity low coupon bonds. When yields are below 6%, then high short-term coupon bondsCoupon BondsCoupon bonds pay fixed interest at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate. are favored.
Also, when the yield is upward-sloping, there is a tendency for bonds with long maturity to be favored, whereas when it is downward-sloping, bonds with short-term maturity will be delivered.
The contract allows the party with the short position to choose to deliver any bond that has a maturity of more than 15 years and is not callable within 15 years. A conversion factor is applicable at the time of delivery of a particular bond in exchange for the price received by the short position for the bond. The applicable quoted price is the product of the recent settlement price for the futures contract and the conversion factor. Taking accrued interestAccrued InterestAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period. into account, the cash received for each $100 face value of the bond delivered is:
- Each contract is for the delivery of $100000 face value of bonds. Suppose that the most recent settlement price is 90-00, the conversion factor for the bond delivered is 1.3800, and the accrued interest on this bond at the time of delivery is $3 per $100 face value.
- The cash received by the party with the short position is then(1.3800*90.00) +3 = $127.20 per $ 100 face value. A party with the short position is one contract that would deliver bonds with a face value of $10,000 and receive $127,200.
Frequently Asked Questions (FAQs)
Bond futures offer several advantages. Firstly, they provide liquidity, allowing market participants to enter and exit positions easily. Secondly, they facilitate efficient trading, as they are standardized contracts traded on organized exchanges. Thirdly, bond futures expose a diversified portfolio of bonds without the need for physical ownership. Finally, they also allow for leveraging positions, potentially amplifying returns.
Bond futures also come with certain disadvantages. One disadvantage is leverage risk, as the use of leverage can amplify losses if the market moves against the position. Additionally, bond futures are sensitive to changes in interest rates, which can lead to price fluctuations and potential losses. Furthermore, bond futures require ongoing contract rollovers, which involve transaction costs and the need for active management to maintain exposure.
Bond futures help manage interest rate risk by allowing market participants to hedge against adverse price movements in bonds due to changes in interest rates, providing a means to protect against potential losses or take advantage of interest rate predictions and market opportunities while maintaining liquidity in the futures market.
This has been a guide to What are Bond Futures. Here we explain the concept with examples, how they work, conversion factors, and deriving the cheapest delivery. You can learn more about from the following articles –