What it means
Because bond prices move inversely to interest rates, a bond future is really a way of trading interest rates. Buying the future gains value if yields fall and bond prices rise, while selling it gains if yields rise.
That symmetry makes the contract a convenient tool for anyone whose finances are sensitive to interest rate movements. The contracts are standardised in every respect except price.
The exchange sets the contract size, typically $100,000 of face value for a Treasury note future, the deliverable bonds, the delivery month and the tick size, so all that participants negotiate is the price. Quotes are traditionally expressed in points and thirty-seconds, so 112-16 means 112 and 16/32, which is 112.50% of face value.
Trading is done on margin, which is where most of the risk and most of the appeal lie. A trader posts an initial margin that is a small fraction of the contract value and is then credited or debited daily as prices move, a process called marking to market.
That leverage means both gains and losses on the margin posted are far larger in percentage terms than the underlying price move. The main commercial use is hedging.
A pension fund holding long-dated bonds can sell futures to reduce its exposure ahead of an expected rate rise, and a corporate treasurer expecting to issue bonds in three months can sell futures to lock in something close to today's borrowing cost. The hedge is never perfect, because the futures contract and the actual exposure rarely move by exactly the same amount.
A quirk worth knowing is the cheapest to deliver bond. Because several different bonds can satisfy delivery, the seller chooses the one most advantageous to deliver, and pricing therefore reflects that choice rather than any single bond.
This is one reason futures based hedges need periodic adjustment rather than being set and forgotten.
In practice
Real-world examples.
Example
A pension fund expecting rates to rise sells government bond futures against part of its long-dated bond portfolio. When yields duly rise, the gain on the futures offsets much of the fall in the portfolio's market value.
Example
A property developer plans to issue $50 million of bonds in four months and sells futures to lock in a borrowing cost close to today's level. Rates rise before issue, and the futures gain offsets most of the higher coupon it has to pay.
Example
A bank's trading desk buys bond futures ahead of a central bank meeting, expecting a signal that rates have peaked. The meeting produces the opposite message, prices fall, and the desk takes a loss on margin within two days.
Formula
Calculation
Contract value = Quoted price as a percentage of face value x Contract size. Profit or loss = (Exit price - Entry price) x Contract size x Number of contracts.
A treasurer expects interest rates to fall and buys 10 Treasury note futures, each covering $100,000 of face value, at a quoted price of 112-16.
Quoted price 112-16 = 112 + 16/32 = 112.50% of face value
Contract value = 112.50% x $100,000 = $112,500 per contract
Total notional exposure = 10 x $112,500 = $1,125,000
Initial margin is set at $2,000 per contract, so the cash posted is 10 x $2,000 = $20,000.
Rates fall and the price rises to 113-16, which is 113.50% of face value.
New contract value = 113.50% x $100,000 = $113,500
Gain per contract = $113,500 - $112,500 = $1,000
Total gain = 10 x $1,000 = $10,000
Return on margin posted = $10,000 / $20,000 = 50%
That 50% return came from a price move of less than 1%, which is exactly what leverage does. The same move in the opposite direction would have wiped out half the margin and triggered a call for more cash.Case study
Seen in the real world.
Calder Ridge Housing Trust is an invented not-for-profit landlord used here as an illustrative example. It had board approval to issue $60,000,000 of 25 year bonds to fund a development, but the issue could not be launched for five months while planning conditions were settled. With yields at 4.2% the finance director calculated that a one percentage point rise before issue would add roughly $600,000 a year to interest costs for a quarter of a century.
The trust sold government bond futures to hedge a large part of that exposure, posting margin from its liquidity reserve. Yields did rise before issue, so the trust paid a higher coupon than it had hoped, but the gain on the futures position offset a substantial share of the extra cost when spread over the life of the debt.
The illustrative complication was operational rather than financial. Two months in, a sharp move against the position generated a margin call larger than the treasury team had modelled, and cash had to be moved at short notice. Calder Ridge afterwards wrote a policy requiring any futures hedge to be accompanied by a stressed margin reserve, on the basis that a hedge you cannot fund is not a hedge at all.
Watch out
Common mistakes.
- Thinking of the notional contract value as the amount at risk. The margin posted is the immediate cash commitment, but losses are not limited to it, which is why a small adverse move can demand substantial additional cash.
- Assuming a futures hedge exactly offsets the underlying exposure. The contract tracks a standard deliverable bond, not your specific bonds or planned issue, so some basis risk always remains.
- Forgetting the cash flow timing of margin calls. Gains and losses settle daily, so a hedge that works over five months can still create an awkward funding need in week three.
Questions
People also ask.
Do I have to take delivery of the bonds?
Almost never, because the great majority of contracts are closed out before expiry by taking the opposite position.
What does a quote like 112-16 mean?
It means 112 and 16/32 as a percentage of face value, so 112.50%, which on a $100,000 contract equals $112,500.
Are bond futures suitable for a company treasury?
They can be, for hedging a known future issue or a rate sensitive portfolio, but they require margin capacity, daily monitoring and board level policy limits before use.
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