T-Bond Futures have reached all-time highs and why we're still bullish on them

We are seeing Treasury Futures prices hitting historic highs. The knee-jerk reaction is to say that they are over-valued. Indeed, there has been talk of a bond bubble. While we agree that all bubbles must eventually come to an end, we have reason to suspect that there is still a good deal of potential upside to this market.

We had initially believed that t-bond futures prices could realistically only go so high, perhaps 136 seemed like a good ceiling. But one of our colleagues was the first to indicate that bond prices were likely to go up more, because for the last 18 of 19 years, bond futures prices had gone up between the months of August and February.
We remain unsure of the causal basis for this phenomenon, but it is sufficient for us to acknowledge that it just exists.

After some more in-depth research and analysis, we believe that the T-Bond futures prices could go even higher before busting. How high? We have no idea, but its plausible that if we are truly entering an era of Japan-like interest rates, T-bond futures could reach as high as 167-09+.

We actually have no idea as to where the top of this bond market might be. In fact, we may have reached the top already. What we do know, however, is that it's ill-advised to arbitrarily pick a top to this market for no reason, other than because it either looks good on a chart or because you think that bond futures prices are range-bound. The only for-sure thing is that yield cannot go below zero. If there were no yield to discount future cash flows, the present value of bonds would equal the sum of all future cash flows. While completely unrealistic, zero-yield would mean that T-Bond futures would be trading close to 190-00 (per $100 par value).

We'll explain how we came up with 167-09+ as possible top for this market in a moment, but if you are unfamiliar with the particulars of T-Bond Futures, please read the footnote at the bottom of this post(1). If you are familiar with the terms and concepts of money market instruments and their derivative products, please read on...

We believe that 167-09 could be an extreme high for T-bond futures because that would be its price if the US Treasury Yields become like Japan's. Although yield is subordinate to price, it is often more useful to consider bonds in terms of yield rather than price because we know for certain that yields cannot be lower than zero. Yields also give us a comparative basis by which to judge our Treasury Bonds against other bonds, whether they are foreign government bonds, municipal bonds, or corporate bonds.

With the increasing concerns of an economic slowdown or even of a double-dip, the effects of a prolonged and unavoidable deleveraging, there has been talk that the US is entering a new regime of ultra-low interest rates. It is has even been suggested that the US will likely follow suit after Japan. Yields on JGBs (Japanese Government Bonds) are significantly lower than those on US Treasury securities.

The likelihood of this scenario remains a topic of heated debate. Some argue that Japan leads the US economy by a decade. Others claim that it is impossible to have an apples-to-apple comparison between Japan and the United States. For our part, we don't take a hard stance on this issue, but we do believe that the circumstances that caused Japan's ultra-low interest rates are similar to the current economic conditions facing the US. The reason that Japanese yields were hit especially hard was because the Japanese recession of 2008 came when it was still limping from a deflationary crisis that had plagued it throughout the 1990s. While the US economy has proven more resilient, if fears of deflation are realized in the coming years, you can bet that yields are going lower. Although we don't think that while US Treasury yields are not likely to become as low as Japan's, it is in the realm of possibility, and also a useful thought experiment.

For the sake of discussion, let us assume that this is possible, and that we are entering this new regime of low yields. We crunched some numbers for you, and here are our results.

First, we examine the current yields on US Treasury securities:

(Data courtesy of Bloomberg.com)

Then compare them to JGBs.

(Data courtesy of Bloomberg.com)

Next, we look at the fair value detail of the CTD bond. It is a 6% coupon, so there is no need to perform any conversions.

(Fair value calculations courtesy of Bloomberg Professional)

This tells us that, given our initial input values for the US Treasury nominal yield curve, T-Bond future prices should be at 135-19 (the last two numbers are quoted in 1/32nds) upon delivery. At the time that this data was run, the futures were trading close to 134, which reflect the positive basis between cash and futures.

And finally, we interpolate the points from the JGBs onto our fair value analytical tool, and we get the following:

(Fair value calculations courtesy of Bloomberg Professional)

This chart tells us that if US Treasury yields go to Japan's current levels, the T-Bond futures could trade higher than 167. 

We would like to acknowledge that we utilized Bloomberg's Professional Terminal to run the scenario analysis. We do not endorse any products, but we must admit that Bloomberg's Professional Terminal is very powerful in the right hands.

Our time's up for now. Stay posted as we continue to provide you with facts-based analysis of the derivatives markets.

- MTL



FOOTNOTE:

1. Because we don't expect everyone to be familiar with  the fundamentals of the t-bond futures contract, we'll briefly review some bond concepts. The T-Bond futures contract is traded at the Chicago Board of Trade. The contract's par value is $100,000, with price quoted as a per cent of the par value. The price value of 1 points is $1000, and the tick size is 1/32 of 1 point ($31.25 per tick). The options tick in 1/64 of 1 point ($15.625 per tick).
   
   As with all futures contracts, the futures fair value equals the spot price plus carry. Carry is comprised of financing costs minus earnings (and/or interest-payments). For a 6% coupon Treasury Bond, the carry is currently negative so the futures trade at a discount to the spot (i.e., you earn money above the prevailing financing costs by holding the cash bonds). The T-Bond Futures price reflects what the current market value of a 6% coupon is expected to be at delivery. The contract is settled in actual US Treasury Bonds with at least 15 years remaining until delivery. Any coupon is eligible for delivery. To put different coupon bonds on roughly equal footing upon delivery, the long position receives an invoice which is the futures price multiplied by a conversion factor plus any accrued interest. The short position decides which bonds to deliver and when to deliver them. It is to the short's advantage to deliver the cheapest possible issue of bond (called the CTD, or "cheapest to deliver), which is determined by the difference between the repo (repurchase) rate and the implied repo rate (IRR). The bond issue where the difference between the repo rate and the implied repo rate is the least negative is the CTD issue. As long as the yield curve is positively sloped, the cheapest date of delivery is the last possible day, which makes sense because the short accrues more interest for holding the bond than he must pay in interest for borrowing the money to hold the cash bond.
   
   As of right now, the cheapest to deliver bond is the 6% coupon with a maturity date of 02/15/26, but that will not always be the case because this issue will be ineligible for delivery into the March 2011 contract. That the 6% is currently the CTD is somewhat convenient because it nullifies the need to convert the CTD issue into the 6% coupon, which the futures contract pricing assumes. This will be important when we look at the fair value of the CTD issue under the given yield curve interpolations.