Trading Bonds Against the Zero Bound

At Attain, we value alternative investment education almost as much as alternative investment itself. That’s why we started writing our weekly newsletter, and expanded our efforts with this blog. And it’s why we’re happy when a customer comes to us with a question – we relish the chance to provide an answer – or find it, if we don’t yet know.

Recently, one of our clients asked us a question about the long bond trade most managed futures program have on right now (looking for bonds to keep going up/rates down); specifically, he wanted to know how CTAs that are long bonds can hope to continue making money on the trade with interest rates almost at zero – the so called Zero Bound.  His thinking – rates can’t go below zero (and very likely won’t get anywhere close to zero), so how can a trade which is looking for rates to keep going lower (towards zero) work out?

This does seem intuitive to think a trade without much room to run is no good, but it’s not quite the case, for reasons we covered in our newsletter last August. The answer comes down to the fact that we’re trading bond futures, not bonds themselves. While rates may be zero bound, the expectation is that rates will rise at some point. This means that the December 2012 futures are priced with the expectation that rates will be higher than the Sep 12 futures, and the 2013 higher than 2012, and 2014 higher than 2013, and so on.  This creates a scenario where the further out prices are lower than the nearby prices, a situation we in the futures world call backwardation.

Here’s the excerpt from our newsletter concerning backwardation:

Backwardation

If you are asking how bonds can trend any higher from their current record highs, pat yourself on the back – that is some advanced thinking and we have asked ourselves the same question over and over. There is a possibility that bonds don’t provide the crisis period performance they have in the past because of their already high levels. How do you go any higher?

But the limited time structure of futures contracts provides some relief for the bond sector and long positions by managed futures in bonds at these record levels.  You see, while current bond prices are at or near record levels (rates at record lows), the anticipation amongst speculators and hedgers is not that they will stay that way indefinitely, but that eventually rates will rise.

This can be seen by taking a look at the Euro Dollar futures curve out 7 years, which shows a steadily declining price for Euro Dollar futures the further we go out in time. This declining futures curve is referred to as backwardation, and when a market is in it – yet the trend is up – that is a good thing for those long that market.

To see how backwardation can help those long the futures, imagine a trend following program buying the Sep. 2013 Euro Dollar futures, which are at essentially 99 in the graph above. This is telling us that traders expect rates to go from their current level of nearly 0 (Euro Dollars are quoted as 100 minus the interest rate, and are currently at 99.62) to a rate of 1%.

Now, imagine that the world economy doesn’t get any better, and Euro Dollar rates don’t rise. If rates stay near zero for the next two years (which Ben Bernanke said was going to happen in the US, didn’t he?), the futures contract will have to rise up to 99.7 to come into equilibrium with the real rates at that time. So, even though rates don’t move at all, the futures may rise in order to erase the discount built into future prices in anticipation of rates rising.

Now, consider that most bonds markets are in backwardation, and have been that way for the better part of the last 10 years (if not 30 years as bonds have been in the midst of a 30 year bull market), and you can see that managed futures don’t particularly need bonds to keep going higher – but just to remain at their current levels for long positions to work out.

One last thing to keep in mind is that futures could theoretically price in negative yields in bonds. We’re almost there, and did get there in TBills at the height of the crisis in 2008, when people were actually paying the government to hold their money, instead of being paid to loan the government their money. A rare occasion to be sure, but sometimes that extra security can be more valuable than returns… and would be just another reason why you could potentially profit from bond futures even when rates are near that zero bound.

Caveat –  there are a few CTAs who look at the amount of potential profit on a trade when analyzing whether to take it and how much risk it is worth. For example, in a market like corn, they know the price can’t go below zero. So, a trader may calculate how much profit there is from current levels to 0, and if that amount isn’t enough greater than what they are risking on the trade, they can pass on the trade or reduce their exposure to bring the risk/reward ratio in line with their model.