Futures contracts are derivatives that allow the holder of the contract to buy securities at a certain price, at a certain time in the future. And investors can subscribe or buy futures contracts for just about any marketable security. However, bond futures are by far the most popular type of futures contract. The reason? They are governed by interest rates, which have a significant impact on all other financial markets in the world.
Whether you’re hedging your bond portfolio against interest rate risk or trying to take advantage of market signals ahead of a rate change, bond futures are the way to go. Investors usually write or buy futures on 2, 5, 10 and 30 year Treasury bills. Additionally, each offers varying potential for risk mitigation and return on investment.
To understand the value of bond futures and how to trade them properly, here is an overview of how they work.
Specifications and prices of bond contracts
Simply put, a future contracts is an agreement between two parties to trade securities at some point in the future – bonds, in this case. The investor who writes the contract sets out the terms. In addition, the purchaser of the contract pays a premium to secure the rights to these terms. For example, here is what the specifications of a bond contract generally include:
- Month of contract (duration and expiry)
- Contract size (number of titles)
- Deliverable Notes (type/quality of link)
- Quote (stock prices)
- tick size (minimum price fluctuation)
Drafting a contract is a debtor action. However, buying a contract is a credit action. Ultimately, the seller of the futures contract is obligated to deliver bonds to the buyer in accordance with the specifications of the contract.
The contract price for a bond futures contract has a direct inverse relationship to the interest rate of the bond. The higher the interest rate, the lower the price of the futures contract and vice versa.
Institutional Bond Futures
The largest providers of bond futures are institutional investors. In fact, this includes banks and insurance companies. These institutions have a vested interest in the bond market. Specifically, interest rates that affect the products they sell, such as investment securities or insurance policies. Bond futures allow them to hedge against volatility that can affect the market and their cost of doing business.
As mentioned, the bond futures market is prolific and liquid. Not only are US Treasuries actively traded every day, there is a steady influx of futures to accompany them. This provides institutional investors with the ability to adapt to changing rate environments. As a result, investors can better protect large bond portfolios.
The advantages of futures contracts
Derivative markets differ from securities markets in that no product changes hands, only contracts. As a result, there is constant activity from hedgers, speculators, margin traders and arbitrageurs which continues to proliferate the number of contracts and trades. This all adds up to some very specific benefits for those looking to get into bond futures.
- Bond futures trade around the clock and are highly liquid, which makes them useful for adjusting to changes in global interest rates in real time.
- Like any derivative, bond futures allow investors to leverage a large investment with a small capital, allowing for large returns.
- The sheer volume of contracts allows speculators to identify options that exactly match their guess.
Ultimately, the benefits of bond futures come down to nimble opportunities to adapt to changing interest rates, which have the potential to affect a variety of investment markets. Savvy investors who can move quickly to get the right futures contract can hedge their own bond portfolio and even profit handsomely from speculation.
The Disadvantages of Futures Contracts
Like any derivative, bond futures carry a high level of risk because they are speculative. No one can predict future prices and rates. Speculators on both sides of the trade take on a certain level of risk, either losing the contract premium or delivering bonds at above market value. There are also additional risks.
- Derivatives trade on margin, which makes investors vulnerable to the reverse effects of leverage. Speculation gone wrong can result in significant losses.
- The unique quoting practices, delivery policies and expiration cycles of US Treasuries can be confusing to those who don’t understand the underlying bond market.
- Because bond futures are so prolific, the market can often move faster than investors. Those without access to sophisticated quoting and trading systems can quickly fall behind.
While the stability of the broader bond market and the high-profile nature of interest rates do much to dampen volatility, bond futures are nonetheless speculative. This makes them better for hedging and arbitrage.
How to profit from bond futures
There’s a reason the bond futures market is one of the most prolific of all. Financial markets. Interest rates have ripple effects across the globe, making them one of the most important economic indicators for everything from lending and borrowing to foreign exchange.
Investors are constantly clamoring to get ahead of any impending rate change and bond futures are the best way to do that. And although it is often speculation, this speculation can serve as a hedge or a route to profit.
While bond futures are more common among institutional traders, retail investors can also participate in this highly liquid and potentially profitable market by using margin accounts. It is important to keep in mind that unlike the bond market in general, the bond futures market is fast, volatile and aggressive.