by Aaron Fennell

Investors tend to flock to U.S. Treasury bonds during times of economic crises, as they are considered the safest of investment vehicles. However, it’s not impossible for that trend to change. There are a variety of futures contracts based on popular foreign bonds you can trade in addition to U.S. Treasuries, and it’s essential to know what drives pricing in these vehicles in order to navigate a potential sovereign debt crisis.

We have seen the threat of sovereign debt crisis unfolding in Europe, and the market chaos that resulted. Traders should understand how the various bond markets behave during such a crisis—particularly if it spreads outside the Eurozone.

Usually, when people talk about “bonds” in general, they are likely referring to the U.S. 30-year Treasury bond (“long bond”), which has a $100,000 notional value per contract. They are priced based on a 6 percent bond coupon yield.

30-Year U.S. Treasury Bond Futures

Trading Unit: $100,000 notional value of U.S. Treasury bonds with 6 percent coupon
Contract Months: March, June, September and December
Contract Type: Physical Delivery of U.S. Treasury bonds
Price Quotation: Points ($1,000) and 1/32 of a point. For example, 134-16 represents 134 16/32. Par is on the basis of 100 points.
Price Fluctuation: One thirty second (1/32) of one point ($31.25), except for the inter-month spreads, where the minimum price fluctuation shall be one-quarter of one thirty-second of one point ($7.8125 per contract)
Exchange: CME Group

Pricing of Bond Contracts
To understand the price structure of bond futures generally, you need to know how the cash-and- carry model works. The fair value of a bond futures contract is the price required to maintain neutral model. That means there would be no advantage in borrowing cash, buying the bond and holding it to the end of the futures contract versus just buying the futures contract. If there was an advantage to one strategy over another, professional traders would bring the prices back in line by trading these strategies against each other.

If futures prices were too high relative to the underlying bond prices, then large arbitrage traders would borrow cash, buy the underpriced bonds, and sell the futures contracts. They would remain long the actual bond and short the futures contract until delivery, and then deliver that bond that was underpriced into the futures position.

In the next graphic, you can see how this relationship works. The black line represents the price of the bond futures contract, and the blue line the price of the cash bonds. Usually the price of the futures contract will be below the price of the physical bond, because when you buy a bond, you have to put the full value of the bond upfront. When you buy futures, you only have to put up a portion of that value. You have to incorporate a cost-of-carry into the bond price.

You can see this when you look at the prices of various futures contract months. The June 2010 contract is trading at about 123 26/32, the September at 123 09/32, and the December contract at 121 29/32. If you are long futures, the price implies the difference in yield between the long bond and the cost of borrowing money. There is a complex formula to calculate the price of a bond futures contract, but in simple terms, futures prices represent the pricing exposure of the underlying bonds.
One thing to keep in mind when you are looking at historical charts of U.S. Treasury bonds: At the beginning of 2000, the exchanges changed the reference/deliverable bond from a 7 percent yield to a 6 percent yield, and you’ll see a huge price gap on the futures charts as a result. You can ignore those types of gaps on bond charts in early 2000.

Bond prices trade inversely to their yield, and prices typically surge during financial or economic crises. This might seem somewhat counterintuitive. When there is uncertainty in the market and tight credit, you would expect long-term interest rates would rise because investors are less confident in the likelihood of getting their money back. Even lending to the U.S. government could be risky if the entire financial system faces collapse.

Many people feared this would happen in 2008—but it didn’t. What we saw during that time was that when more bad news came into the market, U.S. Treasury bond prices climbed dramatically, and yields were extremely low. At the same time, the market was being flooded with cash via actions from the Federal Reserve (easing monetary policy) and the U.S. Treasury (printing more money). Normally this would result in fears about inflation, and inflation typically drives yields up and bond prices down. Traders around the world were terrified of losing money, and U.S. Treasuries seemed like the safest investment they could move into quickly.

During the financial crisis of 2008 there a term coined which you still hear frequently today: the “risk trade.” Every time there was bad news, traders and investors would move their money out of what they perceived to be risky assets, including stocks, some currencies, and many commodities, and they move into what they perceived as safer investments, namely U.S. Treasuries and the U.S. dollar. So on days we see bad news, the U.S. stock market tends to decline, and U.S. bond futures prices move up.

In 2008, the crisis in the U.S. was related to banking and the mortgage industry, not the nation’s sovereign debt. However, the U.S. is running a huge deficit, and it’s possible that could result in problems. If we had a sovereign debt crisis in the U.S. and it lost its AAA credit rating, we’d likely see a very different result in the bond market than we saw in 2008.

Some highly respected analysts and commentators believe the U.S. could lose its AAA rating sometime between 2014 and 2015 if it continues running large deficits. Those forecasts are based on calculations that take into account the country’s debt-to-GDP ratio and directly compare them to the formulas used by the major credit rating agencies. Once the ratio reaches a certain level, it can trigger a reduction in the credit rating, which can in turn cause a sovereign debt crisis and a so-called “run on the bank” for that country (such as we saw in Greece this year).

If the credit rating of the U.S. drops, you would expect the price of U.S. bonds to drop significantly as demand for them falls. We saw this happen in Greece when it threatened to default on its sovereign debt; Greek bond yields climbed to ridiculously high levels in a short period of time. Though in the past this has been considered unlikely in the U.S., in reality, it can happen to any country.

In a recent Bloomberg interview, Former Treasury Secretary Paul O’Neill said it’s not “out of the question” the U.S. could have a Greek-style debt crisis within a few years. He said the U.S. has unfunded liabilities of $63 trillion, and said “by best estimates” these will continue to grow. These are promises to taxpayers and other parties. “If we leave things the way they are for 20 years, I think we are on a very bad course,” he said.  To enable this type of spending, the U.S. and other countries have borrowed against their social security or pension plan dollars.

Canada Government Bond Futures

U.S. bonds aren’t the only government bonds you can trade, although the fundamentals behind their pricing are essentially the same. Canada bond futures are fairly similar to the U.S. Treasury bond contact in terms of specifications, but the time to maturity is shorter, between eight and 10 ½ years.

Trading Unit: C$100,000 nominal value of Government of Canada Bond with 6 percent notional coupon
Contract Months: May, June, September
Price Quotation: Per C$100 nominal value
Contract Type: Physical delivery of eligible government of Canada bonds
Price Fluctuation: 0.01 – C$10

June Canada bond futures are trading at a pretty high level right now, but are priced lower than U.S. Treasury bond futures. This is mainly because Canadian short-term interest rate yields have risen. If the reward for investing in the short-term is insignificant, that will entice investors to move into longer-term instruments. The Bank of Canada increased its key short-term lending rate in June, and has indicated it will likely be raising interest rates further over the next six months. This has caused long-dated bond prices to drop a bit.

Even if the Canadian economy outperforms the U.S. economy (in the absence of sovereign debt problems), Canadian government bonds could perform worse than U.S. bonds in terms of price. Bond prices are a reflection of the credit quality of a country, as well as the relationship between short- and long-term interest rates. Until the U.S. Federal Reserve starts raising its key short-term rates, sees an increase in inflation, or faces a reduction in credit quality, there should be a floor under U.S. long bond prices. It might be a year or two away before any of these events occur.

British Long Gilt Futures

Traders can also consider British bond futures, called long gilts. They are very highly priced right now, as British short-term interest rates are low. The contract specs for long gilts are similar to the U.S. and Canada bonds.

Trading Unit: £100,000 nominal value of British guilt with 6 percent notional coupon eight years and nine months to 13 years to maturity.
Contract Months: March, June, September and December
Price Quotation: Per £100 nominal value
Contract Type: Physical delivery of eligible government gilts
Price Fluctuation: 0.01 - £10

German Euro Bund Futures

German bond (bund) futures are a notional long-term debt instrument with a term of 8 ½ - 10 ½ years, and an interest rate of 6 percent. They are even more highly priced than U.S., Canadian, or British bonds. If you think a sovereign debt default is likely in the Eurozone, you might want to short these contracts.  Europeans in less-credit worthy countries are likely moving their money from risky government bonds (“the PIIGS” countries) to what they perceive as safer German euro bonds. They are supported by the German government, which is in good shape by most measures.

Contract Size: EUR 100,000
Contract Months: March, June, September and December
Quotation: In a percentage of the par value, carried out two decimal places
Price Fluctuation: 0.01 percent, representing a value of EUR 10.

It’s often difficult to find the exact relationship between the strength of a country and the price of its bonds, but what is clear is that when there is a sovereign debt crisis, prices tend to drop rapidly. There is an opportunity for speculators to trade bonds in this case, as well as for investors with physical bond holdings to hedge using the futures markets.  I encourage you to explore these concepts further, and would be happy to discuss more detailed strategies based on your particular situation.

View more detailed contract specs for these products and other futures markets you can trade with Lind-Waldock here: http://www.newtofutures.com/futures_contract.pdf
Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Past performance is not indicative of future results. Please carefully consider your financial condition prior to making any investments. Not to be construed as solicitation.

Lind-Waldock, a division of MF Global Canada Co.

MF Global Canada Co. is a member of the Canadian Investor Protection Fund.

(c) 2010 MF Global Holdings Ltd.

Futures Brokers, Commodity Brokers and Online Futures Trading. 123 Front St. West, Suite 1601, Toronto, ON M5J2M2. Toll-free 877-501-5463.