The New Ultra 10-year Treasury February 2016

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The New Ultra 10-year Treasury

Odd Effect (and Opportunity) from Volume Migration

Alright- just being able to write this piece makes me “Old”- categorically. Back

before low-latency, high-frequency trading, we had to worry about stuff like

“failed auctions”, “illiquidity in the long end”, bad, unthinkable bond monsters.

Treasury auctions weren’t oversubscribed. Primary dealers actually had to buy

Treasuries at auction, hold ‘em for a while, and find a home for the securities.

Unlike Eurodollar futures, S&Ps futures, and other non-deliverable/cash-settled

forwards (i.e. indices and benchmarks), Treasury futures are fully arbitrage-able:

Buy the cash, finance the cash to delivery date, sell the futures, deliver the cash

(or the opposite—sell/borrow/buy/take delivery). Ultimately, delivery

guarantees that pricing will be 100% accurate in the relationship of Treasury

cash and Treasury futures. There is a HUGE difference between correlation and

arbitrage—ask LTCM. Delivery=Arbitrage.

The relationship is known as the Treasury Basis and there is a terrific, all-

inclusive book written by Galen Burghardt called “The Treasury Bond Basis”

outlining the many idiosyncrasies beyond my two-sentence explanation. If your

library has the book, it’s likely available for immediate check-out. Between

Basel III and the Treasury’s reduced coupon issuance for the foreseeable future,

I’d go so far as to say this is a “must read” for any institutional end-user of

Treasury securities—cash or futures. What’s old is new.

Here’s the punchline for this write-up: If you use Treasury futures and operate,

generically/bulk duration, in the 7-10year sector, LONGs should be in the June

Ultra 10-year future (UXYM6 Comdty on Bloomberg™) and SHORTs should use

the “Old TY” future (TYM6 Comdty on Bloomberg™). It’s early in the roll, but

current BASIS levels and open interest in the respective contracts indicate this

rule-of-thumb will hold for the near-future.

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Why? (1) Carry per unit duration and (2) Convexity per unit duration both favor

LONG in Ultra and SHORT in TY. While beyond the scope of this discussion, there

is a condition in the TY BASIS that is known as “negative basis net-of-carry”

indicating that there is a “negative delivery option value” to the SHORT in the

TYM6 futures contract relative to the “cheapest to deliver” security. The effect

of this anomaly is to reduce CARRY in the futures contract.

Graphic #1 Active Basis Market

Futures are a “dirty-price” instrument—meaning coupon, repo cost and

delivery option value are all wrapped-up in the trading price. In effect, (repo

cost)+(delivery option value) = Implied Repo Rate. For simplicity, “CARRY” in

futures is determined by: (the COUPON on the cheapest to deliver cash

Treasury) MINUS (Implied Repo Rate). Again for simplicity, as IRR increases,

CARRY decreases. As CARRY decreases, the futures price “goes up less” over

time (kind of like a zero coupon bond—it’s going “up” over time but the size of

the [net] coupon determines how fast it accretes in price). If IRR ever exceeds

the coupon, the Treasury future would have “negative CARRY”—and “go down

in price” over time.

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Graphic #2: Deliverability and Price at Horizon

The above illustrates a few things: (1) that the Cash Treasury that is currently

cheapest to deliver (CTD) in Row 1 of both futures contracts, is not projected to

change—even with rates +/- 50 basis points in yield (hence the 0’s to the far

right of the rows under the rate shifts), (2) Carry is nearly twice as great (per

contract) in the Ultra vs the TY(look beneath the 0 rate shock in the gold boxes),

and (3) the change in value for UXYM6 is about 12 points and that of TYM6

about 8 points over the same 100bps range.

So, applying the quick math to these numbers:

DV’01 UXYM6 ≈ $12,000/100bps ≈ $120/bp

Carry /DV’01 Ultra = (18+ ticks)/$120= 0.154 ticks/unit rate sensitivity

As for the Old 10-year future:

DV’01 TYM6 ≈ $8,000/100bps ≈ $80/bp

Carry/DV’01 TYM6 = (9+ ticks)/$80= 0.119 ticks/unit rate sensitivity

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Or, put in terms of hedge ratio, it takes:

$1200/$800=> 1.5 TYM6 per 1 UXYM6 to be rate neutral (though still curve risk)

Selling 1.5 TYM6 carries with a cost of: 1.5 x 0.119 = 0.1785 ticks

Vs.

Selling 1.0 UXYM6 carries with a cost of: 1.0 x 0.154 = 0.154 ticks

No doubt, in carry terms per-unit-duration, better to be SHORT TYM6—by 15%+

One of the reason Treasury futures are so compelling to use as a hedge vehicle

(versus a specific Cash Treasury Security), is that Treasury Futures allow for

delivery of multiple securities—BASIS math determining which security in the

basket of potentially-deliverable IS cheapest/most advantageous to deliver.

When rates move, changes in the CTD typically occur. The effect of these

changes is to make the futures contract less positively convex than a single issue

(and what creates delivery option value—for those of you dying to read the

Burghardt Basis Book).

To more readily compare the convexity difference, it’s necessary to view the

RATE SHOCK in a wider window—say, +/-200bps. A window this wide will

generally force a change in CTD—and highlight one of the nuances in the new

Ultra-10yr contract.

The “Old 10-year”, TYM6 contract, has a basket of fifteen (15) potentially

deliverable Treasury securities. The new “Ultra 10yr”—due to re-opening of

current issues and general scarcity of cash 10’s in float—has only two (2)

potentially deliverable securities and only one of the two that, even in +/-

200bps rate shock, is mathematically CTD.

The TYM6 contract, thus, is less positively convex than that of the UXYM6 10-

year contract.

Consider the same Bloomberg™ shock analysis screen with the window opened

up to +/-200 bps:

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Graphic 3) Wide-Range Shock Effect on TYM6 vs UXYM6 to illustrate Convexity

The switch in CTD (follow the 0’s in Row 1, far right of top half), depict a change

in CTD from 2.125 of 12/22 to 2’s of 2/23 with a “rates way up” scenario.

Switching to the 2’s of 2/23 changes the convexity profile of the TYM6 future.

“Hey, wait that’s bogus!”—not at all. These futures were designed as HEDGE

vehicles—as in, benefits of contract behavior should accrue to the SHORT. And,

typically they do—the SHORTs picks what to deliver (though few ever get that

far) and also benefit by the changes in CTD. Changes in CTD make the future “go

down in price” faster—behave in a less positively convex manner.

BUT…with only two cash T’s in the delivery basket for the Ultra, there is no

change in CTD. So, by the effect of discounting at a higher rate, the CTD loses

DV’01 as rates head a bunch higher—the Ultra goes down “less fast” (aka:

UXYM6 is more positively convex).

So what’s it worth to the LONG? Using our hedge ratio from the first half of this

discussion, let’s say we want to compare prospective P&Ls for a total of

$120,000/basis point of risk: 1,000 UXYM6 and 1,500 TYM6—same risk

equivalents.

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If rates are DOWN/UP 200 basis points, the performance would be (according to

the Bloomberg™ Shock in Graphic 3 above):

AND- THERE IT IS (above)! On an equal DV’01/Duration/Risk basis, The ULTRA

10yr (UXYM6) will make more and lose less than the “Old” 10-year Treasury

Future.

If you’re gonna be LONG, in the sector with futures, you wanna own UXYM6.

AND, if you’re gonna be SHORT, launch the TYM6 contract instead.

Back to basis basics-

JC for the Fixed Income Group

The Fixed Income Group at RJO: 800-367-3349 ©Copyright 2016 The Fixed Income Group at RJO