ultra 10-year treasury vs classic ty future- quirks in the basis & ctd basket create directional...
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The New Ultra 10-year Treasury February 2016
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
The New Ultra 10-year Treasury
Odd Effect (and Opportunity) from Volume Migration
Alright- just being able to write this piece makes me “Old”- categorically. Back
before low-latency, high-frequency trading, we had to worry about stuff like
“failed auctions”, “illiquidity in the long end”, bad, unthinkable bond monsters.
Treasury auctions weren’t oversubscribed. Primary dealers actually had to buy
Treasuries at auction, hold ‘em for a while, and find a home for the securities.
Unlike Eurodollar futures, S&Ps futures, and other non-deliverable/cash-settled
forwards (i.e. indices and benchmarks), Treasury futures are fully arbitrage-able:
Buy the cash, finance the cash to delivery date, sell the futures, deliver the cash
(or the opposite—sell/borrow/buy/take delivery). Ultimately, delivery
guarantees that pricing will be 100% accurate in the relationship of Treasury
cash and Treasury futures. There is a HUGE difference between correlation and
arbitrage—ask LTCM. Delivery=Arbitrage.
The relationship is known as the Treasury Basis and there is a terrific, all-
inclusive book written by Galen Burghardt called “The Treasury Bond Basis”
outlining the many idiosyncrasies beyond my two-sentence explanation. If your
library has the book, it’s likely available for immediate check-out. Between
Basel III and the Treasury’s reduced coupon issuance for the foreseeable future,
I’d go so far as to say this is a “must read” for any institutional end-user of
Treasury securities—cash or futures. What’s old is new.
Here’s the punchline for this write-up: If you use Treasury futures and operate,
generically/bulk duration, in the 7-10year sector, LONGs should be in the June
Ultra 10-year future (UXYM6 Comdty on Bloomberg™) and SHORTs should use
the “Old TY” future (TYM6 Comdty on Bloomberg™). It’s early in the roll, but
current BASIS levels and open interest in the respective contracts indicate this
rule-of-thumb will hold for the near-future.
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
Why? (1) Carry per unit duration and (2) Convexity per unit duration both favor
LONG in Ultra and SHORT in TY. While beyond the scope of this discussion, there
is a condition in the TY BASIS that is known as “negative basis net-of-carry”
indicating that there is a “negative delivery option value” to the SHORT in the
TYM6 futures contract relative to the “cheapest to deliver” security. The effect
of this anomaly is to reduce CARRY in the futures contract.
Graphic #1 Active Basis Market
Futures are a “dirty-price” instrument—meaning coupon, repo cost and
delivery option value are all wrapped-up in the trading price. In effect, (repo
cost)+(delivery option value) = Implied Repo Rate. For simplicity, “CARRY” in
futures is determined by: (the COUPON on the cheapest to deliver cash
Treasury) MINUS (Implied Repo Rate). Again for simplicity, as IRR increases,
CARRY decreases. As CARRY decreases, the futures price “goes up less” over
time (kind of like a zero coupon bond—it’s going “up” over time but the size of
the [net] coupon determines how fast it accretes in price). If IRR ever exceeds
the coupon, the Treasury future would have “negative CARRY”—and “go down
in price” over time.
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
Graphic #2: Deliverability and Price at Horizon
The above illustrates a few things: (1) that the Cash Treasury that is currently
cheapest to deliver (CTD) in Row 1 of both futures contracts, is not projected to
change—even with rates +/- 50 basis points in yield (hence the 0’s to the far
right of the rows under the rate shifts), (2) Carry is nearly twice as great (per
contract) in the Ultra vs the TY(look beneath the 0 rate shock in the gold boxes),
and (3) the change in value for UXYM6 is about 12 points and that of TYM6
about 8 points over the same 100bps range.
So, applying the quick math to these numbers:
DV’01 UXYM6 ≈ $12,000/100bps ≈ $120/bp
Carry /DV’01 Ultra = (18+ ticks)/$120= 0.154 ticks/unit rate sensitivity
As for the Old 10-year future:
DV’01 TYM6 ≈ $8,000/100bps ≈ $80/bp
Carry/DV’01 TYM6 = (9+ ticks)/$80= 0.119 ticks/unit rate sensitivity
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
Or, put in terms of hedge ratio, it takes:
$1200/$800=> 1.5 TYM6 per 1 UXYM6 to be rate neutral (though still curve risk)
Selling 1.5 TYM6 carries with a cost of: 1.5 x 0.119 = 0.1785 ticks
Vs.
Selling 1.0 UXYM6 carries with a cost of: 1.0 x 0.154 = 0.154 ticks
No doubt, in carry terms per-unit-duration, better to be SHORT TYM6—by 15%+
One of the reason Treasury futures are so compelling to use as a hedge vehicle
(versus a specific Cash Treasury Security), is that Treasury Futures allow for
delivery of multiple securities—BASIS math determining which security in the
basket of potentially-deliverable IS cheapest/most advantageous to deliver.
When rates move, changes in the CTD typically occur. The effect of these
changes is to make the futures contract less positively convex than a single issue
(and what creates delivery option value—for those of you dying to read the
Burghardt Basis Book).
To more readily compare the convexity difference, it’s necessary to view the
RATE SHOCK in a wider window—say, +/-200bps. A window this wide will
generally force a change in CTD—and highlight one of the nuances in the new
Ultra-10yr contract.
The “Old 10-year”, TYM6 contract, has a basket of fifteen (15) potentially
deliverable Treasury securities. The new “Ultra 10yr”—due to re-opening of
current issues and general scarcity of cash 10’s in float—has only two (2)
potentially deliverable securities and only one of the two that, even in +/-
200bps rate shock, is mathematically CTD.
The TYM6 contract, thus, is less positively convex than that of the UXYM6 10-
year contract.
Consider the same Bloomberg™ shock analysis screen with the window opened
up to +/-200 bps:
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
Graphic 3) Wide-Range Shock Effect on TYM6 vs UXYM6 to illustrate Convexity
The switch in CTD (follow the 0’s in Row 1, far right of top half), depict a change
in CTD from 2.125 of 12/22 to 2’s of 2/23 with a “rates way up” scenario.
Switching to the 2’s of 2/23 changes the convexity profile of the TYM6 future.
“Hey, wait that’s bogus!”—not at all. These futures were designed as HEDGE
vehicles—as in, benefits of contract behavior should accrue to the SHORT. And,
typically they do—the SHORTs picks what to deliver (though few ever get that
far) and also benefit by the changes in CTD. Changes in CTD make the future “go
down in price” faster—behave in a less positively convex manner.
BUT…with only two cash T’s in the delivery basket for the Ultra, there is no
change in CTD. So, by the effect of discounting at a higher rate, the CTD loses
DV’01 as rates head a bunch higher—the Ultra goes down “less fast” (aka:
UXYM6 is more positively convex).
So what’s it worth to the LONG? Using our hedge ratio from the first half of this
discussion, let’s say we want to compare prospective P&Ls for a total of
$120,000/basis point of risk: 1,000 UXYM6 and 1,500 TYM6—same risk
equivalents.
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
If rates are DOWN/UP 200 basis points, the performance would be (according to
the Bloomberg™ Shock in Graphic 3 above):
AND- THERE IT IS (above)! On an equal DV’01/Duration/Risk basis, The ULTRA
10yr (UXYM6) will make more and lose less than the “Old” 10-year Treasury
Future.
If you’re gonna be LONG, in the sector with futures, you wanna own UXYM6.
AND, if you’re gonna be SHORT, launch the TYM6 contract instead.
Back to basis basics-
JC for the Fixed Income Group
The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO
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