What it means
Governments sell debt in different maturities. In the United States, Treasury notes mature in a few years up to ten years, while Treasury bonds run for longer periods, up to thirty years.
Futures contracts on both trade on exchanges, which allows investors to trade the price difference between them. The name tells you the position: notes over bonds means you hold the notes and sell the bonds.
You are long note futures (you profit when their price rises) and short bond futures (you profit when their price falls). Because both legs respond to the same interest rates, much of the overall rate movement cancels out.
What remains is the difference in how the two maturities move. Longer bonds are more sensitive to interest rate changes than shorter notes.
If long-term yields rise faster than medium-term ones, the bond leg falls more than the note leg, and the position makes money in what is called a steeper yield curve. Traders usually adjust the number of contracts so that the two legs have a similar sensitivity to rate changes, often described as being duration-weighted.
Without that adjustment, the position would still carry a view on the direction of rates. The weighting is worked out from each contract's price sensitivity, and the exact ratio varies with market conditions.
For a manager outside the trading world, the idea is useful as a way of reading the market. A strengthening demand for notes over bonds suggests that investors expect the yield curve to change shape.
A treasury team can follow such spreads as signals even if it never trades them.
In practice
Real-world examples.
Example
A fund manager expects long-term yields to rise faster than medium-term yields. She buys note futures and sells bond futures in a duration-weighted ratio. If the yield curve steepens as she expects, the spread widens in her favour.
Example
A bank treasury has a large book of long-dated bonds and uses a notes-over-bonds position as a partial hedge. The position is intended to offset the change in the curve's shape. The treasurer monitors it daily against the bank's risk limits.
Example
A proprietary trader sees that the spread between note and bond futures has moved to an unusual level compared with its history. He opens a small position, expecting it to return to its normal range. He sets a stop at a $5,000 loss for the position.
Formula
Calculation
NOB spread = note futures price - bond futures price
Profit on one pair = change in spread (in points) x $1,000, because each contract has a $100,000 face value and one point is 1% of that
Suppose note futures trade at 110 and bond futures at 120, so the spread is 110 - 120 = -10. Later notes rise 0.5 points to 110.5 and bonds fall 0.5 points to 119.5, so the spread is 110.5 - 119.5 = -9. The spread has moved by 1 point, and the profit on one pair is 1 x $1,000 = $1,000, made up of $500 on the long note contract and $500 on the short bond contract.Case study
Seen in the real world.
Cobalt Ridge Capital is a fictional hedge fund that believed the yield curve was too flat. In this illustrative story, it opened a notes-over-bonds position of 200 pairs of contracts. Each pair had a face value of $100,000 on each leg, so the notional amount on each side was $20,000,000.
Over the next three months the curve steepened and the spread moved by 2.5 points in the fund's favour, a gain of 2.5 x $1,000 x 200 = $500,000. However, in a later month a surprise central bank announcement moved the spread against the fund by 1.5 points, a loss of $300,000. The fund's risk manager concluded that a spread trade is smaller in risk than an outright rate bet but is far from risk-free.
Watch out
Common mistakes.
- Treating a spread as risk-free. The two legs can move differently, and large moves in the curve shape can produce losses.
- Ignoring the weighting between the legs. Without adjusting for duration, the position carries an unintended view on the level of interest rates.
- Forgetting margin and financing. Futures positions require margin, and losses must be covered promptly.
Questions
People also ask.
What does NOB stand for?
Notes over bonds, meaning long Treasury note futures and short Treasury bond futures.
Why would someone trade it?
To profit from a change in the shape of the yield curve or to hedge exposure to it, without taking a large view on the direction of rates.
Who trades the NOB spread?
Mostly professional traders, funds and bank treasury desks, because it needs a futures account and careful risk monitoring.
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