A prolonged selloff in US Treasuries is creating a potential opportunity for hedge funds and other relative-value traders to exploit pricing discrepancies between Treasury futures and the underlying bonds, according to a report by Bloomberg.
Yields on long-dated government debt have climbed above 5%, reaching levels not seen for almost two decades, while the speed of the move is increasing the risk of disruption in the Treasury futures market.
The resulting volatility is creating an opportunity in the so-called Treasury basis trade. Traders can short Treasury futures while buying the cash bond considered cheapest to deliver (CTD) against the contract, allowing them to capture pricing differences between the two markets.
An additional source of potential returns comes from the “switch option”. When Treasury yields move sharply, the bond that represents the cheapest security available for delivery can change. Traders with short futures positions can then switch into the newly designated CTD and potentially capture the resulting price differential.
The opportunity is becoming more relevant as pressure builds at the long end of the US yield curve. A heavy corporate bond issuance calendar this week coincides with a 20-year Treasury auction and a sale of long-dated inflation-protected securities, helping push 30-year Treasury yields to their highest level since 2007.
Data analysed by Bloomberg suggests that a further 10 basis-point increase in long-term yields could cause the CTD to move from the current August 2045 4.875% Treasury to the February 2046 2.5% issue. A 30 basis-point rise from current levels could move the CTD further along the delivery basket, to the August 2049 2.25% bond.
Barclays strategists Andres Mok and Amrut Nashikkar have highlighted the growing significance of this switch risk, particularly with long-end yields above 5%. They noted that a major selloff could push the CTD further out along the eligible bond basket, while a sustained Treasury rally could have the opposite effect.
For hedge funds pursuing the strategy, however, the opportunity is not without risks. Transaction costs and the timing of switches can quickly reduce the potential returns. Changes in the CTD can also require futures traders to adjust hedge ratios, forcing additional buying or selling of contracts and potentially adding to market volatility.
Although switch-option trades remain a relatively specialised form of Treasury arbitrage, the combination of elevated yields, uncertainty over the Federal Reserve’s policy outlook and renewed pressure from higher oil prices could provide a more fertile environment for relative-value strategies.
