Everyone knows about the debt crisis in Greece, most recently spreads above Bunds hitting record 410 basis points, and Greece playing a bailout version of duck, duck, goose with the French, Germans, the IMF and the Arabs (??). However, what is happening in Greece is a reflection of what is happening across a lot of the other developed nations. Recently the PIIGS have come into play as they are the closest to Greece in terms of size, deficits and of course eurozone membership. But we cannot forget about the veteran of debt accumulation: the United States. With the total outstanding debt breaching 13 trillion USD, and record level of debt issuance in 2009 and 2010 to finance the increasing deficit. It is my view that the Fed has been and will continue to keep base rates ultra low to suppress the yield curve so they can issue as much debt as they can at these low interest rates. It is important to remember that the treasury locks in these rates for the entire maturity of the issue. The following chart shows the increase in issuance by the US Treasury over the past 14 months.
US Debt Outstanding by Type - billions (SIFMA Research)
As can be seen the total debt outstanding has steadily increased over the last 14 months with the focus of issuance on T-notes (2-10 years), with bills decreasing and bonds remaining put.
However, this focus on debt on the shorter end of the yield curve presents susceptibility to rollover risk (the US only has to ask Greece about the pitfalls of this), and the US Treasury have stated that their goal is to lengthen the average maturity of their debt to distance themselves from this risk.
The basic idea of this yield curve trade is simple: go long the short end of the curve and short the long end of the curve, therefore betting that the yield curve will steepen.
Lets start with the drivers for the short position:
- As previously mentioned, at some point to extend the maturity of the debt the Treasury will flood the market with longer term bonds. This will create a natural downward pressure on prices.
- Because of the huge deficit and debt to GDP, the far end of the yield curve will steepen as investors demand higher returns to hold what is perceived as riskier debt. Even though the US will not default, if it starts printing money the value of the dollar will plummet and foreign holders of bonds will demand higher yields to compensate. Either way, driving prices lower
The risk with going only short long term bonds is that in the case of any credit event in Greece or any of the other countries in the Eurozone, there will be a massive sell off of risky assets and a 'run home to mommy' reflex into treasuries as seen every-time the market has hiccuped over the past year. Therefore by going long short term treasury bills/notes, you can focus on the state of the US debt and hedge the effects of a flight to quality would have. In the case of a flight to quality, the shorter term treasuries will more than offset the loss in the short position as investors will want to hold shorter term debt. In addition, investors seem to be very receptive to short term bond issuance with the recent 3 year auction having a 3.1 bid to cover.
The Trade Itself
First we need to figure out the maturities that we want to play, then figure out the method through which to accomplish the trade, and finally relevant position sizes/risk limits/profit targets.
Looking at the yield curve (Bloomberg):
As can be seen, the yield curve is already extremely flat at 1Y and shorter, and quickly steepens past the 1Y mark. Therefore it makes sense to go long the 2Y instead of the shorter bills as there is very little room for bill yields to go lower (and therefore little room for prices to move upwards). Short will compose of the 30Y bond.
Since shorting bonds requires a trader to deal with OTC markets and repo rates, the simplest way to put this trade on is to look at CBOE Bond Futures which are actively exchange traded. The 30Y trades in ticks of 0.01 with each tick being 31.25 USD per contract. On the other hand, the 2Y contract changes with ticks at 0.002 with 15.63 USD per tick for a single contract.
CBOE 2Y Futures Contract:
CBOE 30Y Futures Contract:
To get a position size, we need to equate the two contracts by considering their tick specifications as well as volatility, which will be gauged through the average true range.
Since 5 ticks of the 2Y = 1 tick of 30Y
therefore for a 0.01 move in the contract, the 2Y changes by 15.63*5 = $78.15 ($31.25 for 30Y).
Therefore from this we know that we need to hold 31.25/78.15 = 0.3999 number of 2Y contracts for each 30Y contract. However, we also need to account for the volatility, as the more volatile the contract, the less of it we need to hold to play the spread.
Therefore [ATR(30)/ATR(2)]*[0.3999] gives us the vol adjusted ratio.
Contract ratio = [0.873/0.12723]*0.3999 = 2.74
Therefore for each 30Y contract, we need to hold 2.74 2Y contracts to keep the spread ratio appropriate. This ensures that the two contracts are on equal footing.
Disclosure: No Positions