Speculating on Interest Rates With Bond Futures

The advantages and disadvantages of investing in futures instead of actual securities.
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Last week, we talked about ways you can profit from a big move down in interest rates, if that's what you expect. The best options, we concluded, are to buy either

Treasury Strips

-- zero-coupon bonds -- or shares of a mutual fund that acts like a Treasury Strip. Strips and Strips funds will outperform regular Treasuries and regular Treasury funds if rates drop sharply, and because there's no coupon income to reinvest, it's simpler to realize the total return.

As a reminder, if Treasury yields continue to rise instead of fall, Strips and Strips funds will perform worse than anything else in the Treasury universe.

At the end of last week's piece, I said we'd talk about how to use futures and options on futures to speculate on interest rates. We'll do futures this week, options next. And I want to preface the discussion by saying that these are complicated topics, and I'm only going to lay out the basic concepts. Don't use any of these strategies without a professionally supplied understanding of the financial and tax consequences. There's a reason only about 15% of the volume in bond futures on the

Chicago Board of Trade

represents individual investor activity.

Accordingly, your friendly online broker probably doesn't have the ability to let you do bond futures and options transactions electronically, if at all. At the very least you're going to have to talk to someone on the phone. (A full-service broker, by contrast, can certainly put a futures trade on for you.)

The advantage of speculating on interest rates with futures instead of actual securities (a.k.a. the cash market) is that you can do it with much less money. Say you want to speculate on a big move down in interest rates in the cash market with $100,000 face amount of long Treasuries. You're going to have to spend something on the order of $100,000 to buy the bonds (unless you're buying Strips, in which case you'll spend less, but you will still have to spend at least $17,000 for a long-maturity instrument).

In the futures market, you can capture the approximate price movement on $100,000 face amount of long Treasuries with as little as $2,700. (Approximate because different long Treasury issues perform differently, and the futures contract will tend to track the worst performer, for reasons explained in a previous

column. Still, in a big rally, even the worst performer will do extremely well.)

The main disadvantage is that $100,000 is the smallest face amount of bonds whose price change you can capture. If the market goes against you, the magnitude of that price change might be a larger loss than you can handle.

Here's how it works. Treasury futures and options on them are listed on the CBOT, whose

Web site has loads more information than you'll find in this column.

The Treasury bond futures contract is an agreement to take delivery of $100,000 face amount of Treasury bonds when the contract expires. Hardly anyone ever actually takes delivery of the bonds, though. Instead, futures traders typically "close out" their positions before the delivery month arrives, and open a new position in the next contract. For example, the most active contract at the moment, December,

requires the owner to take delivery of the bonds during the delivery month, by the last business day. So by the end of November, traders will "roll into" the March contract, closing out their positions in the December contract to avoid having to either take delivery (if they are long) or deliver (if they are short). At that point, the March contract becomes the most active. After March comes June, then September.

You don't pay anything in the conventional sense to establish a futures position. Instead, you post margin.

Say you'd gotten long the December contract at last night's closing price of 112 9/32, by calling your broker placing the order. (A previous

column explained the relationship between the futures price and the cash bond price.) The contract has a value of $112,281, but you don't pay that amount. You post

initial margin, which for the Treasury contract is at least $2,700 (per contract).

Each day, your position will be marked to market, and you may have to post additional margin. Say the futures settles a point lower today, at 111 9/32. The value of your position will have dropped by $1,000. That $1,000 loss will be subtracted from your margin account.

In addition to the initial margin requirement, there is also a maintenance margin requirement. For the bond future, it is $2,000. That's the minimum that has to be in your margin account at all times.

By the same token, if your position increases in value, the gains will be added to your margin account, and you can withdraw them, down to the initial margin level. In the case of a 100-basis-point drop in yields, the gain on the futures contract would be roughly 10 1/2 points, or $10,500 per contract, since the dollar value of each basis point of yield change equates to about 0.105 of a price point on the contract. (This concept is also explained in the

piece on the relationship between the futures price and the cash price.)

You can see that by using futures, it is possible to capture the gain on a $100,000 block of bonds without having to lay out something close to $100,000 at the outset. In addition, the transaction cost on a single contract may be less than on a small quantity of bonds, since exchange-traded futures are a more liquid market than cash. But you should also be able to see that it is possible to lose a lot relative to the size of your initial investment. It's called leverage, and it's very risky.

As a side note, the CBOT has made a change to the Treasury bond contract beginning with the March contract that causes it to trade at a lower price than the December contract. (A recent

story explains the development.) If you invest in the December contract and then roll into the lower-priced March contract, this shift will not affect your return. If, for example, the December contract goes to 114 and you close out your position, you will realize that profit. Buying the March contract at 95, or wherever it happens to be trading, should have no effect on your final return on the investment.

Send your questions and comments, along with your full name, to

fixed-incomeforum@thestreet.com. Fixed-Income Forum appears every Friday.

TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.