Bond Futures

What Are Bond Futures?

Bond futures are financial derivatives that obligate the contract holder to purchase or sell a bond on a predefined 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 terms (price and the expiration date) of the contract are chosen at the time the future is purchased or sold.

Bond Futures Explained

A futures contract is an agreement entered into by two parties. One party consents to buy, and the other party consents to sell an underlying asset at a predetermined price on a predefined date from here on out. 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, like a bond.

Bond futures are contractual agreements where the asset to be delivered is a government or Treasury bond. 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, considering the free flow of trades without delays.

The bond futures contract is utilized for hedging, speculating, or arbitrage purposes. Hedging is a form of investing in products that give protection to holdings. Speculating is investing in products that have a high-risk, high-reward profile. Arbitrage can happen when there's an imbalance in prices, and traders attempt to create a gain through the simultaneous purchase and sale of an asset or security.

At the point when two counterparties enter into a bond futures contract, they settle 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 instance, say a party is short — the seller — a 30-year Treasury bond, and the seller must deliver the Treasury bond to the buyer at the date indicated.

A bond futures contract can be held until maturity, and they can likewise be closed out before the maturity date. Assuming the party that established the position closes out before maturity, the closing trade will result in a profit or a loss from the position, contingent upon the value of the futures contract at the time.

Where Bond Futures Trade

Bond futures trade fundamentally on the Chicago Board of Trade (CBOT), which is part of the Chicago Mercantile Exchange (CME). Contracts typically terminate quarterly: March, June, September, and December. Instances 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)

Bond futures are supervised by a regulatory agency called the Commodity Futures Trading Commission (CFTC). The job of the CFTC incorporates guaranteeing that fair trading practices, equality, and consistency exists in the markets as well as preventing fraud.

Bond Futures Speculation

A bond futures contract permits a trader to speculate on a bond's price movement and lock in a price for a set future period. On the off chance that a trader bought a bond futures contract and the bond's price rose and closed higher than the contract price at expiration, then the trader has a profit. At that point, 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.

On the other hand, 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 prior to expiry, and the gain or loss could be net settled through the trader's account.

Bond futures can possibly generate substantial profits since bond prices can fluctuate widely over the long haul due to shifting factors, including changing interest rates, market demand for bonds, and economic conditions. Nonetheless, the price fluctuations in bond prices can be a situation with two sides where traders can lose a significant portion of their investment.

Bond Futures and Margin

Numerous futures contracts trade through margin, meaning an investor just has to deposit a small percentage of the total value of the futures contract amount into the brokerage account. In other words, the futures markets typically utilize high leverage, and a trader doesn't have to put up 100% of the contract amount while entering into a trade.

A broker requires a initial margin and, although the exchanges set least margin requirements, the amounts can likewise differ contingent upon the broker's policies, the type of bond, and the creditworthiness of the trader. Notwithstanding, 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. On the off chance that the funds are not deposited, the broker can liquidate or unwind the position.

Know the implications of leverage (trading utilizing margin) before trading futures; your brokerage firm will have information about least margin requirements on their website.

The risk to trading bond futures is potentially unlimited, for either the buyer or seller of the bond. Risks incorporate the price of the underlying bond changing drastically between the exercise date and the initial agreement date. Likewise, the leverage utilized in margin trading can exacerbate the losses in bond futures trading.

Delivery With Bond Futures

As mentioned before, the seller of the bond futures can pick 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 permitted to satisfy the futures contract terms. The utilization of CTDs is common with trading Treasury bond futures since any Treasury bond can be utilized for delivery for however long it is within a specific maturity range and has a specific coupon or interest rate.

Futures traders typically close positions a long time before the possibilities of delivery and, in fact, numerous futures brokers expect that their customers offset positions (or roll to later months) a long time before the futures expiration is at hand.

Bond Conversion Factors

The bonds that can be delivered are standardized through a system of conversion factors calculated by the rules of the exchange. The conversion factor is utilized to adjust coupon and accrued interest differences of all delivery bonds. The accrued interest is the interest that's accumulated but to be paid.

Assuming a contract indicates that a bond has a notional coupon of 6%, the conversion factor will be:

• Short of what one for bonds with a coupon under 6%
• Greater than one for bonds with a coupon higher than 6%

Before the trading of a contract occurs, the exchange will declare the conversion factor for each bond. For instance, 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 accessible in the futures market.

Dealing with a Bond Futures Position

Every day, before expiration, the long (buy) and short (sell) positions in the traders' accounts are marked to market (MTM), or adjusted to current rates. At the point when interest rates rise, bond prices decline — since existing fixed-rate bonds are less attractive in an increasing rate environment.

Then again, on the off chance that interest rates decline, bond prices increase as investors race to buy existing fixed-rate bonds with attractive rates.

For instance, let's say a U.S. Treasury bond futures contract is entered into on Day One. Assuming interest rates increase on Day Two, the value of the T-bond will diminish. The margin account of the long futures holder will be debited to reflect the loss. Simultaneously, the account of the short trader will be credited the profits from the price move.

On the other hand, in the event that interest rates fall instead, bond prices will increase, and the long trader's account will be set apart to a profit, and the short account will be debited.

A trader chooses to buy a five-year Treasury bond futures contract that has a $100,000 face value implying 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 $99,000 futures position. Throughout the next couple of months, the economy improves, and interest rates start to rise and push the value of the bond lower.

Profit or loss = number of contracts * change in price * $1000

Utilizing the formula above, we can calculate the profit or loss. Expect at expiration, the price of the T-bond is trading at $98 or $98,000. The trader has a loss of $1,000. The net difference is cash-settled, meaning the original trade (the buy) and the sale are netted through the investor's brokerage account.

The Bottom Line

Bond futures obligate the contract holder to either buy or sell a bond at a predetermined price on a specific date. There are benefits and downsides to futures trading- - the consistently fluctuating market can increase profits significantly but it likewise puts them at greater risk. Before buying into futures, it is important to analyze advantages and disadvantages and connect with your brokerage firm about their specific policies.

Highlights

• Bond futures are utilized by speculators to bet on the price of a bond or by hedgers to protect bond holdings.
• 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 contracts that entitle the contract holder to purchase a bond on a predetermined date at a price determined today.
• Bond futures indirectly are utilized to trade or hedge interest rate moves.