Is there any downside to investing in bond futures?

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lee1026
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Is there any downside to investing in bond futures?

Post by lee1026 » Tue Jul 22, 2014 9:08 pm

Relative to investing in bond funds, that is. From what I can see, there are a lot of upsides to futures vs bond funds, such as tax treatment of gains (capital gains rather then ordinary income), the amount leverage that you are potentially able to deploy, and lower fees because you are not paying any fund fees.

Is there any downsides that I should be aware of?

acegolfer
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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Tue Jul 22, 2014 9:14 pm

All derivatives have leverage effects that increases the risk and magnifies the returns. To many investors, increased risk is the downside to investing in futures.

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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Tue Jul 22, 2014 9:19 pm

Sure, but in theory, if a person puts $N dollars into a futures account, and trade on a bond future worth $N, it would be the same as if that person never leveraged, right?

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Tue Jul 22, 2014 9:45 pm

lee1026 wrote:Sure, but in theory, if a person puts $N dollars into a futures account, and trade on a bond future worth $N, it would be the same as if that person never leveraged, right?
No. That's not how futures works.

When you long or short a futures contract, you have to deposit cash into your margin account to meet the initial margin requirement, which is much smaller than $N in your example. So it's always levered. Once you set up the margin account, the daily gains of a long contract is roughly the same as how the underlying asset spot price moves.

Two keywords to google: futures initial margin requirement, futures daily settlement
Last edited by acegolfer on Tue Jul 22, 2014 9:50 pm, edited 1 time in total.

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Re: Is there any downside to investing in bond futures?

Post by Taylor Larimore » Tue Jul 22, 2014 9:46 pm

Is there any downside to investing in bond futures?
Lee:

I copied this from Investopedia:
Bond Futures

Bond contracts are standardized, and are overseen by a regulatory agency that ensures a certain level of equality and consistency. However, this form of derivative can be risky because it involves trading at a future date with only current information. The risk is potentially unlimited, for either the buyer or seller of the bond because the price of the underlying bond may change drastically between the exercise date and the initial agreement.
Best wishes.
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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Tue Jul 22, 2014 9:53 pm

There is no unlimited liability for buying a fully collateralized bond future. You pay whatever market price is at the time and when the future matures, someone owes you a $100k face treasury bond. It's true that for US treasuries, the margin requirements for futures are tiny, often around only 2% of the face value of the bond. So if you use the 50:1 leverage, sure, you can lose everything and then some. But even then you're liability is still limited if you bought to the price you paid.

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Re: Is there any downside to investing in bond futures?

Post by 26USC » Tue Jul 22, 2014 9:56 pm

As long as you don't overexpose yourself by trading more notional than you have cash in the account it is essentially unlevered.

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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Tue Jul 22, 2014 9:59 pm

lee1026 wrote:Is there any downsides that I should be aware of?
The near zero interest rates aren't enough of a downside?

Futures need to be rolled as they expire if you want to keep constant exposure (the same way an intermediate bond fund keeps selling bonds approaching maturity to buy longer dated ones). This is a bit of a pain and will also cost something in terms of commissions and spreads. The time cost is likely the biggest part.

Also, futures contracts are pretty big, $100k notional is typical I believe. So you won't be able to do fine grained investing the way you can with a mutual fund or even ETF.

I assume that for anything out to about 5 years, a FDIC bank account or a CD would be better than treasuries, but perhaps there are state tax considerations that make that less clear in some cases. If you wanted some long duration exposure, say from a 10 year or 30 year future, you could get that via futures efficiently. You might also be able to arbitrage the implied risk free (institutional) rate against your FDIC savings account, since the former is lower than the latter. That gets into using the leverage and holding the cash elsewhere where it can earn a better rate, which enhances your return but means you do need sufficient cash at the futures brokerage account to handle fluctuations.

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Tue Jul 22, 2014 10:03 pm

Tanelorn wrote:There is no unlimited liability for buying a fully collateralized bond future. You pay whatever market price is at the time and when the future matures, someone owes you a $100k face treasury bond. It's true that for US treasuries, the margin requirements for futures are tiny, often around only 2% of the face value of the bond. So if you use the 50:1 leverage, sure, you can lose everything and then some. But even then you're liability is still limited if you bought to the price you paid.
Not sure when you meant by "you pay whatever market price is at the time" When buying a futures contact, one doesn't pay the futures price or the underlying asset price. If there's any cash flow when entering into a futures contract, it's cash deposited to your margin account.

The rest I agree.

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Tue Jul 22, 2014 10:03 pm

26USC wrote:As long as you don't overexpose yourself by trading more notional than you have cash in the account it is essentially unlevered.
Can you elaborate this using an example?

AFAIK, to be unlevered, the amount deposited in your margin account must be the same as the underlying asset price, which never happens in a futures contract.

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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Tue Jul 22, 2014 10:07 pm

acegolfer wrote:Not sure when you meant by "you pay whatever market price is at the time" When buying a futures contact, one doesn't pay the futures price or the underlying asset price. If there's any cash flow when entering into a futures contract, it's cash deposited to your margin account.
Thank you for the clarification - I had forgotten about how futures are settled. What I meant was if you had cash in your account equal to the market price, you'd never have a margin problem since the future price shouldn't fall below zero and hence you should never have cumulative outflows from marking the future's price change in excess of the cash you had.

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Re: Is there any downside to investing in bond futures?

Post by Chan_va » Tue Jul 22, 2014 10:14 pm

I don't get what you are trying to do. You don't want to pay bond fund fees but are willing to pay the higher commissions and spreads on a futures contract? If tax implications matter, why not individual munis?

I suppose if you are an ultra high net worth investor and for some reason you had to hold huge amount of treasuries in a taxable account, there may be some edge cases where this might make sense.

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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Tue Jul 22, 2014 10:18 pm

I agree that the interest is kind of low, but that is the same in a bond fund.
Bond contracts are standardized, and are overseen by a regulatory agency that ensures a certain level of equality and consistency. However, this form of derivative can be risky because it involves trading at a future date with only current information. The risk is potentially unlimited, for either the buyer or seller of the bond because the price of the underlying bond may change drastically between the exercise date and the initial agreement.
The bond price can't fall below 0, right? And the amount of money a person need to put into a futures account to ensure that it doesn't go into the negatives even if the bond price fall to 0 is the value of contract in question, right?
You might also be able to arbitrage the implied risk free (institutional) rate against your FDIC savings account, since the former is lower than the latter.
Is it possible to look up what the implied rate on the futures somehow? Can I count on it being around the federal funds rate?
I don't get what you are trying to do. You don't want to pay bond fund fees but are willing to pay the higher commissions and spreads on a futures contract? If tax implications matter, why not individual munis?
Commissions on futures are under a dollar a contract. At the size of 119K per contract, that is chump change. I am unsure how big spreads are, but assuming it is anything close to e-mini spreads, that will end up being trivial as well. As for holding munis, munis carry a default risk and are illiquid, and generally do not rise in value in a crisis, unlike treasuries.
I suppose if you are an ultra high net worth investor and for some reason you had to hold huge amount of treasuries in a taxable account, there may be some edge cases where this might make sense.
If having 119K in bond allocation makes me ultra high net worth, then sure. But I am not even a millionaire, let alone any of kind of ultra high net worth person. And in case you say "use a retirement account", I am too young to have much in 401K and IRA - the combined limit of around 22K a year means that my tax deferred accounts are tiny relative to my taxable account, even though I max both out every year.
Last edited by lee1026 on Tue Jul 22, 2014 10:31 pm, edited 1 time in total.

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Re: Is there any downside to investing in bond futures?

Post by 26USC » Tue Jul 22, 2014 10:23 pm

Suppose you have $500,000 and want to invest it in 10 year treasury futures. Each contract of the CME TY future represents a single $100,000 10 year treasury but only has an initial margin requirement of ~$1,500. So with your $500,000 you could purchase ~333 contracts representing a notional exposure of $33,300,000 (333*1500) and leverage of 66x of your initial $500,000. However if you constrain yourself to buying only 5 contracts your notional will be $500,000 (equal to your cash) and even though you only have to post a margin of $7,500 (1500*5), you can park the rest of your cash in TBills and use if necessary to post additional margin if the position goes against you.

There will be some tracking error to an intermediate term treasury index but not huge, and you will have to roll the futures unless you want to take delivery of the bonds which will have some small costs but don't entail significant risks.

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Re: Is there any downside to investing in bond futures?

Post by market timer » Tue Jul 22, 2014 11:04 pm

lee1026 wrote: Is it possible to look up what the implied rate on the futures somehow? Can I count on it being around the federal funds rate?
If you have access to Bloomberg, you can look up the implied repo rate for the cheapest-to-deliver bond. I'd be curious to know if there are ways to get this info for people without access to Bloomberg. From what I've seen, the implied repo rate is close to 3-month LIBOR; however, there can be complications from optionality when multiple bonds could be cheapest to deliver, depending on what happens to the yield curve prior to expiration. Someone long a future is short the delivery option. More info is available from the CME (see page 12 for discussion of the implied repo rate): http://www.cmegroup.com/education/files ... utures.pdf

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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 12:11 am

Wow.

Let's see if I can simplify things here for lee1026:

Taking the long position in bond futures is (nearly) identical to buying the underlying bond. Period.

(Oh, sure, there are some minor complexities, but, in essence, they're (nearly) identical. I'll hit the complexities in a minute.)

When you buy a bond, you own the bond today. When you take a long position in a bond futures contract, you don't own the bond today, but you have the same risk as if you did, and when the contract expires and you take delivery, you'll own the same bond as you would have had you bought it today. Same upside, same downside, same everything. Absolutely no difference. Period.

The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract. So it's the same as if you were to put today's price into an escrow account today (earning the risk-free rate), and then withdraw it at the end of the futures contract and hand it over to the seller (the short position).

When people say that futures are leveraged, they're referring to the fact that you don't have to put the full price into your margin account today. But if you invest the balance at the risk-free rate, then the portfolio (long futures position plus margin account plus remaining cash invested) is not leveraged. If you plan to do that, then worrying about the leverage of one security in the portfolio is silly.

Finally, the complexities. Well, complexity (there's really only one): because you don't really own the bond until it's delivered at the end of the futures contract, any coupon payments paid during the term of the contract don't come to you; they go to the person who really does own the bond (the short position, presumably). However, because you won't get that interim coupon payment, you don't have to pay for it: the futures price is reduced by the (future, at the end of the term) value of that coupon payment. So you're still left with a portfolio whose value is the same as if you'd bought the bond.

So, in a nutshell, if you don't plan to take advantage of the leverage that bond futures allow you, you might as well buy the bond itself: it's no different.

Period.
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Re: Is there any downside to investing in bond futures?

Post by market timer » Wed Jul 23, 2014 12:34 am

magician wrote:So, in a nutshell, if you don't plan to take advantage of the leverage that bond futures allow you, you might as well buy the bond itself: it's no different.
The tax treatment is also different, since interest income on a cash bond is converted to capital gains on the futures. This is valuable for those of us with carryforward losses.

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 6:18 am

magician wrote: The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract.
F0 = Future value of today's price increased at the Rf?

What do you mean by future value of today's price? How do you know what that will be?

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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Wed Jul 23, 2014 7:00 am

So here's a question for market timer, magician, or someone else who really understands these things:

if you wanted exposure to a 2 year treasury and bought a 2 year future contract for delivery 2 years from now, is the price you would expect to pay now for that future be the notional of the contract discounted by the difference between the risk free rate and the interest rate paid on the 2 year note?

To be more concrete, if risk free was 0.25% and a 2 year treasury paid 1% (both annualized), we would expect the PV of a $100 bond to be $100/(1+0.75%)^2 = $98.52 and hence that would be the future contract price? If so, we could expect to earn both the $1.48 difference between now and maturity by holding the future, as well as whatever we earn on the collateral during those 2 years.

As market timer suggests, this could have advantageous tax treatments since the futures return will be treated as capital gains at 60% long term / 40% short term as a regulated 1256 futures contract, payable each year. This is better than interest on the underlying bond, for at least on the discount PV part (the risk free would presumably invested in a FDIC bank account with similar tax treatment to the original bond).

I understand there are lots of details if you actually wanted to do this (managing collateral and margin call risks, liquidity of long dated futures, and costs of course), but I want to make sure I understand the basics first.

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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 7:41 am

You must post margin in the form of cash or T-bills to trade futures. The transaction costs for an individual buying T-bills through his futures brokerage could be onerous. When T-bills had substantial yields of 3% or more, futures traders who were posting cash margin instead of T-bills were losing some money. In the current environment of effectively zero T-bill yields, this is not a problem.

You can create the risk profile of a bond fund by buying a bond futures contract of a similar duration. Your "expense ratio" consists of the cost of rolling your bond futures contract 4 times a year -- futures brokerage fees and bid-ask spreads (which are very small for liquid contracts such as Treasury note futures). I have traded futures through OptionsXpress, now owned by Schwab. It is convenient because you can own securities and futures in effectively the same account. Their futures commissions are $3.50 per contract. If you made 4 round-trip trades annually, on a contract with $100K notional, the expense ratio due to commissions is a small 0.028% = 4*3.5*2/100000.

Perhaps the biggest downside is that futures trading gives you the ability to take much more risk than you can with mutual funds. You should be confident that you will be disciplined in your risk-taking.

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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 7:49 am

Tanelorn wrote:So here's a question for market timer, magician, or someone else who really understands these things:

if you wanted exposure to a 2 year treasury and bought a 2 year future contract for delivery 2 years from now, is the price you would expect to pay now for that future be the notional of the contract discounted by the difference between the risk free rate and the interest rate paid on the 2 year note?

The question is moot. Two years from now, all that would be left to "deliver" would be the principal of the 2-year note, which is fixed. The only 2-year note futures contracts with any volume at present is for September 2014 delivery. See http://www.cmegroup.com/trading/interes ... -note.html .

If you want tax-advantaged yield, the simplest thing to do is buy a muni bond fund, such as one from Vanguard, and if you want more yield and are willing to take more risk, you can speculate on closed-end muni bond funds selling at discounts and currently yielding about 6%.

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Re: Is there any downside to investing in bond futures?

Post by market timer » Wed Jul 23, 2014 8:19 am

Tanelorn wrote:To be more concrete, if risk free was 0.25% and a 2 year treasury paid 1% (both annualized), we would expect the PV of a $100 bond to be $100/(1+0.75%)^2 = $98.52 and hence that would be the future contract price? If so, we could expect to earn both the $1.48 difference between now and maturity by holding the future, as well as whatever we earn on the collateral during those 2 years.

As market timer suggests, this could have advantageous tax treatments since the futures return will be treated as capital gains at 60% long term / 40% short term as a regulated 1256 futures contract, payable each year. This is better than interest on the underlying bond, for at least on the discount PV part (the risk free would presumably invested in a FDIC bank account with similar tax treatment to the original bond).
As Beliavsky notes, there are some problems with your example. I'd recommend reading the CME paper I linked to earlier. The gist of the advantageous tax treatment is that the futures price will reflect any interest paid. You have the right idea in your example. Any coupon payments made before the futures expiration date reduces the price of the future.

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Re: Is there any downside to investing in bond futures?

Post by Johno » Wed Jul 23, 2014 8:23 am

magician wrote:Wow.

Let's see if I can simplify things here for lee1026:

Taking the long position in bond futures is (nearly) identical to buying the underlying bond. Period.

(Oh, sure, there are some minor complexities, but, in essence, they're (nearly) identical. I'll hit the complexities in a minute.)

When people say that futures are leveraged, they're referring to the fact that you don't have to put the full price into your margin account today. But if you invest the balance at the risk-free rate, then the portfolio (long futures position plus margin account plus remaining cash invested) is not leveraged. If you plan to do that, then worrying about the leverage of one security in the portfolio is silly.

So, in a nutshell, if you don't plan to take advantage of the leverage that bond futures allow you, you might as well buy the bond itself: it's no different.
This is correct as to the key issue of leverage. Using bond futures *allows* you to leverage (perhaps 'tempts' you to leverage, if you're not disciplined). It doesn't *force* you to leverage.

If you have $100k to invest and invest it in either the cheapest to deliver treasury for a particular futures contract (some ~7yr off-the-run issue for the most liquid '10yr note' futures contract) or go long one 10yr note contract, post margin (ca. $1000), leave a few more $k in the brokerage account for sudden margin call, and put the other 90k, say, in a bank account, that's the same leverage. It's only more leverage if *you* choose to go long a bunch of contracts per $100k cash.

What's more, the economics of that futures trade are not the same but far superior to buying the treasury with cash *for the retail investor* (not for the professional). The reason is that the implicit financing rate of the bond in the futures contract is the repo rate, a few bps now for short term. But the individual investor can invest in FDIC insured money market accounts way above the repo rate, .95% for the best bank accounts now. The professional can't invest in zero duration govt risk above the repo rate. So 'lever/delever' investment in futures is an arbitrage for retail investors. However, it's not necessarily superior to investing in medium term CD's, where you're basically using the same arb (some banks' willingness to pay way above the riskless rate because regulators pressure them to attract more retail deposits) directly in a longer maturity. But liquidity issues might still make the futures trade superior, and for very long duration (if you want it) the ultra-treasury futures contract is a much longer underlying than even any brokered CD (AFAIK).

Commissions on bond futures are not remotely onerous if you choose the right broker, ca. $2 per trade per contract. The main cost is that you do have to roll contracts 4 times a year (not practical in general to buy farther out contracts and roll less often; there's tremendous liquidity in the front contract, much less in any other). You'll generally pay a bid or offer to mid of 1/4 of a tick each time (tick =1/32=$31.25 for most bond contracts, 1/2 tick from bid offer in front contract most of the time). So for 8 trades/year/contract (4 contracts, buy/sell each) that's around ~8bps 'expense ratio' on $100k contract, including the commissions, but the .95%-repo spread you get on most of the money on top of the implicit yield will still blow away buying a bond fund or a treasury directly. Again though, it won't blow away a CD. So IMO the choices to buy duration with govt risk are either CD or bank account plus long position in the futures: buying nominal treasuries (or treasury fund) for cash doesn't add up. If one desires inflation protection with govt credit risk OTOH, then cash TIPS offers a feature that CD's and futures can't.
Last edited by Johno on Wed Jul 23, 2014 8:29 am, edited 1 time in total.

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Re: Is there any downside to investing in bond futures?

Post by TomatoTomahto » Wed Jul 23, 2014 8:29 am

This has been interesting to read, but I'd be lying if I said that I understood most of it (magician, you got me the closest to understanding).

So why am I posting anything? Because I wanted to say that there is probably an apropos saying that applies to OP, some blending of "if you have to ask the price, you can't afford it" and "if you're at a poker game and you haven't identified the fish, it's you."

OP, best of luck. Honestly.
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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 8:43 am

acegolfer wrote:
magician wrote: The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract.
F0 = Future value of today's price increased at the Rf?

What do you mean by future value of today's price? How do you know what that will be?
Suppose that a 20-year Treasury Bond is selling today for $1,022.15, and the the 3-month risk-free rate is 0.5% (2.0% annually). Then the price of a 3-month futures contract on that T-Bond is $1,022.15 × 1.005 = $1,027.26. That's the price you'll pay (in 3 months) for that T-Bond.
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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 8:44 am

I had a futures account at MF Global, a large futures brokerage that was bankrupted by the strategies of former Goldman Sachs CEO and New Jersey governor Jon Corzine. My money was frozen more than a year, although I eventually got it all back through the liquidation process. The case of Peregrine Financial was even more egregious (outright theft and forged bank statements sent to regulators), and I don't know what recovery its customers will get.

The futures industry attracts risk-takers, both on the customer side and the brokerage side. I think Vanguard is run by different types of people and has a different class of customers.

The funds of futures traders are by law supposed to "segregated" from those of their brokers, but sometimes they have not been. People contemplating futures should be aware of the fraud/operational risk as well as the market risk. I think the market risk is the dominant one, but fraud and operational risks should not be ignored.

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Re: Is there any downside to investing in bond futures?

Post by Chan_va » Wed Jul 23, 2014 8:46 am

You can simulate a bond using a bond futures. However here are just a couple of things to think about in addition to what's been said- this gets very complex very quickly.

1. You are going to pay a basis spread over a bond - for the privilege of having a futures contract which has some options. The spread varies with maturity and interest rates, but is not totally insignificant.
Lets assume you bought a bond future for a bond maturing tomorrow. In theory, the spread should be zero, since there is close to zero risk, and close to zero options. As you move further out, this widens.

2. Even if you don't use leverage, what you are really doing is arbitraging - Lets say you buy $x worth of bond futures by posting $y in the margin account and $z in cash or bills such that $x=$y+$z. You are still earning interest on y and z, taxed at ordinary income. What you are doing is arbitraging yields of x vs. y and z. It may be worthwhile doing it - but recognize that that's what you are doing

For $120k in bonds, given today's interest rates, I don't think the choice is even close - just buy a muni fund and be done with it.

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Re: Is there any downside to investing in bond futures?

Post by longinvest » Wed Jul 23, 2014 8:59 am

What happens if the bond defaults?
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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 9:02 am

Tanelorn wrote:So here's a question for market timer, magician, or someone else who really understands these things:

if you wanted exposure to a 2 year treasury and bought a 2 year future contract for delivery 2 years from now, is the price you would expect to pay now for that future be the notional of the contract discounted by the difference between the risk free rate and the interest rate paid on the 2 year note?

To be more concrete, if risk free was 0.25% and a 2 year treasury paid 1% (both annualized), we would expect the PV of a $100 bond to be $100/(1+0.75%)^2 = $98.52 and hence that would be the future contract price? If so, we could expect to earn both the $1.48 difference between now and maturity by holding the future, as well as whatever we earn on the collateral during those 2 years.
You have things backward: you're not paying today for something worth $100 in 2 years; you'll be paying in 2 years. So the price you will pay is the future value of today's price on that bond. However, as you don't get the coupon payment, the price is discounted from that of the actual bond; the discount is the future value of those coupon payments.

Suppose that the price of the bond today is $100, and it pays coupons (of $0.50) in 6 months, 1 year, 18 months, and 2 years. You'll get the coupon in 2 years (you'll own the bond by then), but not the other three. So the price will be the future value of today's price ($100 × 1.0025² = $100.50) less the future value of the three coupon payments ($0.50 × 1.0025³′² + $0.50 × 1.0025 + $0.50 × 1.0025¹′² = $1.5038), or $98.9969.
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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 9:05 am

Chan_va wrote:You can simulate a bond using a bond futures. However here are just a couple of things to think about in addition to what's been said- this gets very complex very quickly.

1. You are going to pay a basis spread over a bond - for the privilege of having a futures contract which has some options. The spread varies with maturity and interest rates, but is not totally insignificant.
Lets assume you bought a bond future for a bond maturing tomorrow. In theory, the spread should be zero, since there is close to zero risk, and close to zero options. As you move further out, this widens.
It is the seller of the bond futures contract who has the option of which bond to deliver, and this option lowers rather than increases the price of the bond futures contract. In general, bond futures contracts are priced efficiently, and you do not need to be knowledgable about delivery options to trade bond futures, assuming you roll before expiration.

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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 9:06 am

TomatoTomahto wrote:This has been interesting to read, but I'd be lying if I said that I understood most of it (magician, you got me the closest to understanding).
I'm glad to hear that; thanks.

The takeaway is: unless you're planning to take advantage of the leverage offered (and apart from the differing tax treatment), buying (i.e., taking the long position in) a bond futures contract is exactly the same as buying the underlying bond. You might as well buy the bond and be done with it.
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Re: Is there any downside to investing in bond futures?

Post by longinvest » Wed Jul 23, 2014 9:11 am

longinvest wrote:What happens if the bond defaults?
Bump!
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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 9:28 am

If treasuries default, I have bigger problems then the state of my brokerage account.
The takeaway is: unless you're planning to take advantage of the leverage offered (and apart from the differing tax treatment), buying (i.e., taking the long position in) a bond futures contract is exactly the same as buying the underlying bond. You might as well buy the bond and be done with it.
As MarketTimer and me like to point out, the tax treatment makes it very different for those of us with 6 figure tax loss carry forwards.

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Re: Is there any downside to investing in bond futures?

Post by longinvest » Wed Jul 23, 2014 9:30 am

Can't munis default? I'm just trying to understand the mechanics, not trying to predict doom!
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Re: Is there any downside to investing in bond futures?

Post by Johno » Wed Jul 23, 2014 9:31 am

magician wrote:
TomatoTomahto wrote:This has been interesting to read, but I'd be lying if I said that I understood most of it (magician, you got me the closest to understanding).
I'm glad to hear that; thanks.

The takeaway is: unless you're planning to take advantage of the leverage offered (and apart from the differing tax treatment), buying (i.e., taking the long position in) a bond futures contract is exactly the same as buying the underlying bond. You might as well buy the bond and be done with it.
Again, that final take away is not correct. If you buy $100k of bond you get the treasury yield on $100k. If you go long one ($100k notional) futures contract you implicitly get the yield of the treasury minus the repo rate. But you can invest a large % of the $100k in an FDIC insured account at far above the repo rate. Say you leave 10% of the money in the brokerage account earning zero (the actual margin reqt is ~1%) and put 90% in a top yielding FDIC insured bank account at .95% and assume (very conservatively, it's generally much less in today's market) the repo rate=3M LIBOR ~.25%. That yield arbitrage is then worth an extra 60bps on a ~7yr bond (underlying of the nominal '10 yr' contract) yielding around 2%. That's a relatively large difference from 'exactly the same'.

On other risks, there is as mentioned risk to the broker, but that's only to the extent of cash you leave with the broker, and it's insured via SIPC up to $250k. But the $90k is with a bank, not the broker, FDIC risk. Also in some extreme case you could have collapse of the futures exchange but not the broker. But the amount at the risk there would be just a day's movement in price on the contract (though by past history of crises that would be a big daily move up in treasury prices, exchange would owe you that money if you're long the contract).

As far as tax treatment, that varies with investor and situation (is it in an IRA or taxable?) like anything else: isn't an argument that the arbitrage doesn't exist. And if it's in taxable yes you have pay tax on the .95%, but it's a 95bps you mostly just wouldn't be getting if you invested all the cash in a treasury. You also pay capital gains tax (60% long term/40% short term, regardless of holding period) on changes in the futures price, which is how you're implicitly receiving your treasury yield, so that's actually better than ordinary income treatment of the coupons of a treasury. Comparing it to munis is apples and oranges: muni's have credit risk, for the whole principal. Junk bonds would yield even more, stocks would probably beat any fixed income alternative in the long run, but that's a risk/return question. And again, you might be doing the investing in an IRA.
Last edited by Johno on Wed Jul 23, 2014 9:35 am, edited 1 time in total.

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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 9:33 am

longinvest wrote:What happens if the bond defaults?
If you have the long position in a futures contract, you'll be buying a defaulted bond.

Just as if you'd owned the bond itself. No difference.

(So, you might consider buying a CDS as well . . . .)
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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 9:36 am

Can't munis default? I'm just trying to understand the mechanics, not trying to predict doom!
As far as I can tell, the only liquid futures are all on treasuries. And given the tax treatment, you wouldn't want to buy munis via futures.

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 9:39 am

magician wrote:
acegolfer wrote:
magician wrote: The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract.
F0 = Future value of today's price increased at the Rf?

What do you mean by future value of today's price? How do you know what that will be?
Suppose that a 20-year Treasury Bond is selling today for $1,022.15, and the the 3-month risk-free rate is 0.5% (2.0% annually). Then the price of a 3-month futures contract on that T-Bond is $1,022.15 × 1.005 = $1,027.26. That's the price you'll pay (in 3 months) for that T-Bond.
2 points.

1. Then you should have stated "The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract.
2. I'm sorry but that's not how Treasury futures price are quoted. Unlike other underlying, the futures price is not S0 * (1+r)^T. The underlying asset is not the actual 20-yr T-bond.
Treasury futures delivable
U.S. Treasury notes with an original term to maturity of not more than five years and three months and a remaining term to maturity of not less than one year and nine months from the first day of the delivery month and a remaining term to maturity of not more than two years from the last day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.
http://www.cmegroup.com/trading/interes ... tions.html

If you disagree, then explain how the 2-yr T-note futures quote expiring in 2 months is 109'237 using your formula, when the current 2yr T-note is 100.125.
http://www.cmegroup.com/trading/interes ... -note.html
http://online.wsj.com/mdc/public/page/2 ... asury.html
Last edited by acegolfer on Wed Jul 23, 2014 9:47 am, edited 2 times in total.

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Re: Is there any downside to investing in bond futures?

Post by longinvest » Wed Jul 23, 2014 9:40 am

magician wrote:
longinvest wrote:What happens if the bond defaults?
If you have the long position in a futures contract, you'll be buying a defaulted bond.

Just as if you'd owned the bond itself. No difference.

(So, you might consider buying a CDS as well . . . .)
I think that I'm starting to understand.
lee1026 wrote:
Can't munis default? I'm just trying to understand the mechanics, not trying to predict doom!
As far as I can tell, the only liquid futures are all on treasuries. And given the tax treatment, you wouldn't want to buy munis via futures.
I guess that this settles the question.

Thanks.
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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 9:43 am

acegolfer wrote:
magician wrote:
acegolfer wrote:
magician wrote: The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract.
F0 = Future value of today's price increased at the Rf?

What do you mean by future value of today's price? How do you know what that will be?
Suppose that a 20-year Treasury Bond is selling today for $1,022.15, and the the 3-month risk-free rate is 0.5% (2.0% annually). Then the price of a 3-month futures contract on that T-Bond is $1,022.15 × 1.005 = $1,027.26. That's the price you'll pay (in 3 months) for that T-Bond.
2 points.

1. Then you should have stated "The price of a bond futures will be (surprise, surprise!) the future value of today's price on the bond, increased at the risk-free rate for the term of the futures contract.
The price is the future price, decreased by the future value of the coupons you won't receive. I covered that.
acegolfer wrote:2. I'm sorry but that's not how Treasury futures price are quoted. Unlike other underlying, the futures price is not S0 * (1+r)^T. The underlying asset is not the actual 20-yr T-bond.
The underlying is a theoretical, 20-years-to-maturity, 6% coupon, noncallable T-Bond. The futures price is S0 × (1+r)^T, where S0 is the (theoretical) price for the (theoretical) underlying bond.
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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 9:44 am

lee1026 wrote:
Can't munis default? I'm just trying to understand the mechanics, not trying to predict doom!
As far as I can tell, the only liquid futures are all on treasuries.
The Eurodollar futures market is very liquid, and strips of Eurodollar futures can be used to replicate short term bonds. As with short-term investment grade bond funds, there is a little credit risk, since in a financial crisis, the spread of LIBOR (which is what Eurodollar futures settle to) to Treasury yields widens.

Futures markets are fascinating, but I will repeat my suggestion to invest in muni bonds.

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 9:50 am

magician wrote: The price is the future price, decreased by the future value of the coupons you won't receive. I covered that.

The underlying is a theoretical, 20-years-to-maturity, 6% coupon, noncallable T-Bond. The futures price is S0 × (1+r)^T, where S0 is the (theoretical) price for the (theoretical) underlying bond.
You sound like who knows Treasury futures. But there are still a few points you got wrong.

1. There's no 20-yr Treasury futures. The traded futures are 10yr, 5-yr, 2-yr and 30-yr "Ultra" futures.
2. The formula S0*(1+r)^T is a forward price formula. It works for futures, only if the underlying asset price is unaffected by the interest rate.
3. There's no theoretical 20-yr 6% T-bond selling today for $1022.15. Such price is unobservable. So that formula to calculate futures price is pratically meaningless.
4. To be 100% accurate, the underlying is not a even hypothetical 20-yr 6% coupon T-bond. It's close but not identical. It's well explained in http://www.cmegroup.com/education/files ... utures.pdf
It is likewise tempting to refer to U.S. Treasury bond
and note futures as “6% contracts.” This too may
be somewhat misleading. T-bond and T-note
futures are based nominally upon a 6% coupon
security.
If you disagree, can you explain using your formula to show the 2-yr T-note futures expiring in 2 months with an underlying a hypothetical 2-yr 6% T-note is quoted 109'237 today?
http://www.cmegroup.com/trading/interes ... -note.html
Last edited by acegolfer on Wed Jul 23, 2014 10:23 am, edited 5 times in total.

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Re: Is there any downside to investing in bond futures?

Post by Johno » Wed Jul 23, 2014 10:03 am

Beliavsky wrote:
lee1026 wrote:
Can't munis default? I'm just trying to understand the mechanics, not trying to predict doom!
As far as I can tell, the only liquid futures are all on treasuries.
The Eurodollar futures market is very liquid, and strips of Eurodollar futures can be used to replicate short term bonds. As with short-term investment grade bond funds, there is a little credit risk, since in a financial crisis, the spread of LIBOR (which is what Eurodollar futures settle to) to Treasury yields widens.

Futures markets are fascinating, but I will repeat my suggestion to invest in muni bonds.
I think the suggestion of futures on credit risky bonds was a misunderstanding or mistake; I understand you are saying buy *cash* munis.
But cash purchase of muni's has credit risk for the whole principal, so cannot be compared on after tax yield alone to the other three alternatives (cash treasuries, treasury futures plus bank account, or CD's). Per a given person's credit risk appetite muni's might make more sense, in a high tax bracket. To give illustrative numbers, Vanguard Intermediate Term Muni Admiral (VWIUX) has yield 1.86% at maturity 8.6 yrs, treasury curve at 8.6 yrs~2.29%, plus ~.6% arb of repo v FDIC insured bank account for unlevered futures position, minus .08% cost of rolling the futures~2.81%, so muni yield breaks even at ~34% federal rate. Many people are below that, and again the muni has non-negligible credit risk* on whole principal, futures trade has credit risk (to broker) on only a small % of principal. And muni's aren't relevant at all if one is investing in an IRA.

On Eurodollar futures I agree they (strips of them) are an alternative way to reproduce shorter term bonds, but two points. They also don't reflect govt credit risk. Yes the spread to treasuries of the synthetic bond represented by a strip of Euro's will widen in a crisis, meaning you lose money if you're long that you wouldn't have lost being long treasury futures. You're basically long ~AA/A-ish kind of corporate/financial institution credit risk; theoretically it's (uninsured) bank risk at settlement, but outer contracts are affected by all kind of derivatives transactions influenced by general corporate credit, hard to say really what credit risk exactly is reflected in a Eurodollar strip, but the spread to treasuries will widen in a crisis. Also the nominal size of the Eurodollar contract is $1mil, so a full strip is a $1mil synthetic bond. You can do a partial strip (2 contracts per year) but it's not quite as convenient as $100k bond futures. OTOH, you can put on outer Euro positions and just leave them, not rolling eg. 'gold' contracts till 4+yrs from now. So it's a possible alternative, I agree.

*I personally don't have any interest now in longer term muni's now because I believe that future municipal credit crises (if any) will likely be driven by underfunded public pensions, and that problem gets worse if the stock market performs poorly. That's an unfavorable correlation for 'safe money' IMO. However it is a matter of opinion.

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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 10:27 am

acegolfer wrote:
magician wrote: The price is the future price, decreased by the future value of the coupons you won't receive. I covered that.

The underlying is a theoretical, 20-years-to-maturity, 6% coupon, noncallable T-Bond. The futures price is S0 × (1+r)^T, where S0 is the (theoretical) price for the (theoretical) underlying bond.
You sound like who knows Treasury futures. But there are still a few points you got wrong.

1. There's no 20-yr Treasury futures. The traded futures are 10yr, 5-yr, 2-yr and 30-yr "Ultra" futures.
2. The formula S0*(1+r)^T is a forward price formula. It works for futures, only if the underlying asset price is unaffected by the interest rate.
3. There's no theoretical 20-yr 6% T-bond selling today for $1022.15.
4. To be 100% accurate, the underlying is not a even hypothetical 20-yr 6% coupon T-bond. It's close but not identical. It's well explained in http://www.cmegroup.com/education/files ... utures.pdf
It is likewise tempting to refer to U.S. Treasury bond
and note futures as “6% contracts.” This too may
be somewhat misleading. T-bond and T-note
futures are based nominally upon a 6% coupon
security.
If you disagree, can you explain using your formula to show the 2-yr T-note futures expiring in 2 months with an underlying a hypothetical 2-yr 6% T-note is quoted 109'237 today?
http://www.cmegroup.com/trading/interes ... -note.html
The conversion factors for bonds deliverable against a T-Bond futures contract adjust for the difference between the market price of the actual bond and the theoretical price of a 20-year-to-maturity, 6% coupon, noncallable T-Bond. The theoretical underlying is the 20-year, blah, blah, blah, bond, but as there are no such bonds in circulation, others are allowed to be delivered (with appropriate conversions when their market prices differ from the theoretical). None of this changes the theoretical underlying; it only affects the short's delivery option.
Simplify the complicated side; don't complify the simplicated side.

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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 10:31 am

magician wrote: The conversion factors for bonds deliverable against a T-Bond futures contract adjust for the difference between the market price of the actual bond and the theoretical price of a 20-year-to-maturity, 6% coupon, noncallable T-Bond. The theoretical underlying is the 20-year, blah, blah, blah, bond, but as there are no such bonds in circulation, others are allowed to be delivered (with appropriate conversions when their market prices differ from the theoretical). None of this changes the theoretical underlying; it only affects the short's delivery option.
Thank you for introducing "conversion factor" when the thread is about Treasury futures.

My apologies for being too academic. But when I see a incorrect formula, I can't resist correcting it.
Last edited by acegolfer on Wed Jul 23, 2014 10:38 am, edited 1 time in total.

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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 10:32 am

Also, from what I can tell, Muni funds like to hold to maturity because liquidity is so poor. So the yield to maturity is about the returns you will get. Treasuries, on the other hand, is liquid enough for you to make money by buying the higher yielding, longer duration bonds, and then selling the lower yielding, shorter duration bonds, and that is a very non-trivial source of income. As far as I can tell, that is fully priced into treasury futures as well.

To see how big that difference is, consider buying the 4 year STRIPS, holding for a year, and then selling it as a 3 year STRIPS. The difference in price is 2.52%. You will have to buy very long yielding munis to have a comparable yield and open yourself up for far more interest rate risk.

Treasuries also have less correlation to the overall stock market, which is highly valuable as a hedge to those of us who have considerable stock holdings that we are looking to hedge.

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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 10:40 am

The vast majority of people with securities accounts do not have futures accounts. An alternative way of converting bond ordinary income to capital gains in a securities account is to buy call options on bond ETFs such as TLT. Options do have higher transaction costs, and you also pay a "volatility risk premium". The yield of a bond ETF will incorporated into option prices. If the ETF rises so that your call ends up in the money and is exercised, you have not realized a capital gain. That will happen when you sell the ETF. If you sell the call option before expiration, there will be a capital gain or loss.

The tax arbitrage is probably done most cost efficiently with futures, but I thought I'd mention that something similar is possible with options.

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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 10:48 am

I looked into that first, but alas, TLT does not have a super liquid options market. If I were to go that route, I would be paying out the nose on the bid-ask spread.

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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Wed Jul 23, 2014 10:59 am

lee1026 wrote:I looked into that first, but alas, TLT does not have a super liquid options market. If I were to go that route, I would be paying out the nose on the bid-ask spread.
And you'd need reasonably liquid 1+ year options if you wanted to get long term capital gains instead of short term ones. The difference between short term gains and interest isn't much unless you've got a pile of capital losses.

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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 11:01 am

lee1026 wrote:Also, from what I can tell, Muni funds like to hold to maturity because liquidity is so poor. So the yield to maturity is about the returns you will get. Treasuries, on the other hand, is liquid enough for you to make money by buying the higher yielding, longer duration bonds, and then selling the lower yielding, shorter duration bonds, and that is a very non-trivial source of income. As far as I can tell, that is fully priced into treasury futures as well.
A long-term municipal bond fund, like a long-term Treasury bond fund, will sell bonds with durations much lower than its target and replace them with longer duration bonds.

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