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The Exciting World of Treasury Bond Trading (Seriously)

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March 1, 2013
Bond trading 101
Fredrik Broden

For some people, bonds evoke images of Mortimer and Randolph sipping brandy in smoking jackets, or maybe retirees waiting patiently for their biannual coupon payments. Dull, right? But then there are some traders, for whom bonds represent the biggest, baddest market of them all—the only one that makes the S&P 500 seem like a pipsqueak. You. Me. We're the latter. Or maybe you aren't yet, but you want to be. Or at least you want to take a peek behind the curtain to see what all the excitement is about.

In point of fact, bonds don't have to be just a placeholder for your money. For many traders, bonds are just another trading instrument. Period. And for some investors, they're a default choice for the money you wouldn't, or don't, invest in stocks. Cookie-cutter financial plans often suggest you allocate some percentage of your investments into bonds as a “safe” place for your money, no matter the bond market's condition. As a person who's seen bond futures trading limit down on more than a few occasions, I guess my take on “safe” is a little different than most financial planners.

Bonds 101: Not The Trading Stuff, Yet

First things first. A bond represents debt, unlike a stock that represents ownership. When you buy a bond, whether it's from the U.S. Treasury, a corporation, state or municipality, that entity is borrowing money from you and promises to pay you a fixed rate of return, plus your money back at some future maturity date. How likely that entity is to pay you that money is reflected in the bond issuer's credit rating. Remember when the U.S. lost its AAA rating a couple years ago? That happened because people thought the U.S. was a little less likely to pay its promised bond payments. (Those rating stinkers.) Anyway, a rating naturally impacts a bond's price and volatility.

Because the rate of return is fixed when the bond is issued, bond prices and interest rates move inversely to each other. Interest rates go up, bond prices go down, and vice versa. If a bond pays some coupon rate, say, 5 %, and interest rates drop to 4 %, that 5 % bond becomes more attractive and people will pay more for it. Remember this inverse relationship between interest rates and bond prices. It's important because expectations of changes to interest rates can have a big impact on bond prices. And small, incremental changes in bond prices can have a large impact on the yield of a bond. Yield is the bond's coupon rate divided by the bond's price.

Bonds also have different times to maturity, ranging from CDs and T-bills maturing in a few months, to 30-year Treasury bonds. A bond's maturity not only affects the rate it offers but also its price volatility. In simple terms, a bond with a shorter amount of time to maturity—like a 90-day T-bill—will have a lower coupon rate than a 30-year bond because people generally require less return to take a risk over a shorter amount of time. A somewhat more complex concept is the relationship between a bond's time to maturity and its price volatility. Without getting into all the joys of bond math with modified duration and convexity, suffice it to say that the price of a bond with more time to maturity will be more sensitive to changes in interest rates than a bond with less time. You can see that reflected in the implied volatility (IV) of options on futures for bonds of different maturities. For example, at the time of this writing, overall IV in options on the 30-year Treasury bond future was 9.4%, and the overall IV in options on the 10-year Treasury-note future was 4.8 %. They both have the same credit rating of the U.S. government, but the greater time to maturity of the 30-year bond means larger potential price changes, which can translate into higher IV in options on bond futures. When IV is higher, option premiums become more expensive.

Okay, Which Bonds?

With a basic understanding of how bond prices work, you now have to sift through the range of bond and debt products. Most traders and investors generally consider four types:

1. Government and agency bonds

2. Municipal bonds (or “munis")

3. Corporate bonds

4. Short-term debt

All of these promise to pay interest and return on capital, but they can have different ratings, yields, and maturities. Some are more actively traded than others and offer traders more flexibility. Foreign bonds aren't easily traded in the U.S. by retail investors, and they involve currency and political risks that are beyond the scope of this article.

Government and agency bonds are things like U.S. Treasuries and GNMA (Ginnie Mae) mortgage-backed securities that have high credit ratings and are actively traded. Why? The backing of the U.S. government makes them attractive to a wide range of investors.

Municipal bonds are issued by entities like cities and states that use taxes and other revenue to pay back the bonds. Munis are popular with some investors because of certain tax advantages, but specific muni bonds may not be actively traded and some may be subject to the alternative minimum tax.

Corporate bonds use a company's revenues to pay the bonds and offer a much wider range of credit ratings and yields—from relatively safe names to high-yield “junk” bonds. While bond traders might not trade corporate bonds themselves, they'll sometimes look at the difference in the yields between corporate bonds and Treasuries to see if one may be overbought or oversold relative to the other.

Short-term debt instruments are typically things like T-bills, CDs, and money markets. They have different levels of credit ratings and are more likely to be offered at a discount with principal and interest paid at maturity. You can actually buy any one of these bonds in your TD Ameritrade account. With TD Ameritrade's CD Center and Bond Wizard, you're able to filter through all the bond offerings to find one that meets your criteria for rating, maturity, and yield, and buy it with a few clicks.

As a trader, one potential strategy is to use T-bills as collateral in your margin accounts. T-bills usually have very stable prices because of their short time to maturity, and the timely payment of principal and interest is backed by the full faith and credit of the U.S. government. So, you can borrow against a much higher percentage of the value of T-bills than you can stocks. With most marginable stocks, you can borrow on 30 % to purchase them—meaning you would only need to put up $0.30 for each $1.00 it costs. But depending on your broker/dealer, for T-bills under 20 years in duration, you can typically borrow up to 95 % of their value (i.e. put up $0.05 for each $1.00 it costs). For T-bills over 20 years in duration, it's typically up to 90 % (i.e. put up $0.10 for each $1.00 it costs).The percentage of the T-bill's value that's not available for collateral is called the “haircut.” Traders looking to earn a potentially higher rate on cash in their account, but not take much principal risk and not reduce their available trading capital too much, may buy T-bills. Longer-term Treasury bonds and notes can be used as collateral as well. But they have a bigger “hair cut” because of their higher-price volatility.

As For Trading Them…

If you ask a trader how bonds are doing today, she'll likely answer with only one thing—30-year, Treasury-bond futures. Treasury bond futures and their options (and I'll toss in 10-year T-Note futures and options too) are the most actively traded bond products for retail investors and traders. Munis and CDs are nice, but when traders trade “bonds,” they're mostly trading bond futures and futures options. If you want to trade bond futures, you'll need a futures account. [Certain qualifications and permissions are required to trade futures or options on futures.] But any TD Ameritrade client can see futures quotes on the thinkorswim® platform. For example, type the root symbol "/ZB" for the 30-year bond future, and "/ZN" for the 10-year note future, into a symbol field to see quotes, charts and options. (See Figure 1.)

Bond quotes

FIGURE 1:

Pulling bond quotes on thinkorswim is easy. Just go to the Trade page and type in the symbol (e.g. “/ZB” shown here). The quote you see is the most “active” future trading. For illustrative purposes only.

Pulling quotes: When you pull up /ZB in the Trade page of thinkorswim®, it pulls in the quotes for all the bond-future expirations, which are always in either March, June, September and/or December. There is one most-actively traded future, and it's usually the one with the shortest amount of time to expiration. It's conveniently marked “Active” on the thinkorswim Trade page. The most active future “rolls” to the next expiration when the near-term future gets into its delivery period, as traders with short futures positions can deliver actual Treasury bonds to traders with long futures positions. This isn't something retail traders get into, so keep an eye on that “Active” future indicator and roll positions as needed.

When you pull up /ZB on the Trade page, you'll also see plenty of Treasury bond futures options. The options in the different expirations deliver, and are priced off, futures with corresponding expirations. For example, April, May, and June T bond-futures options deliver June Treasury bond futures. September options deliver September Treasury bond futures. The options’ expirations are a little funky. Their final trading day is the last Friday that precedes by at least two business days the last business day of the month before the stated expiration month of the option. So, June options stop trading on the third Friday of May. Bond futures options are also American-style, meaning they can be exercised at any time before, and including, expiration, and are futures settled—meaning you take or make delivery of one bond futures contract for each option that's exercised or assigned.

One main difference between bond futures, futures options, and equity options is point value. You'll see bond futures quoted in 1/32nd increments and options in 1/64th increments. If /ZB has a price of 145'20, that means the price of the future is 145 and 20/32nds. An option on /ZB might be “58 bid and “60 ask. That's 58/64ths bid and 60/64ths ask. You multiply each of those by $1,000 to get the full point value. A one-point change in the bond future or option is worth $1,000. To clarify further, if you sold a 147 call and bought a 148 call to create a vertical spread in /ZB for a net credit of “22, that credit is 22/64, and would generate $343.75 cash in your account. The max potential loss on the trade is the difference between the strikes of 1.00 point, which is worth $1,000, minus the credit. By example, $1,000-$343.75 = $656.25. That's also 42/64ths x $1,000. So, selling a one-point vertical in bond futures with a max profit of 22/64 has a max potential loss of 42/64 (before commissions).

Trading on margin:

The current margin requirement on each bond future is approximately $3,800 and is based on the estimated likely maximum one-day price change. It can be changed by the CME Group if the estimated risk of the future increases or decreases. Bond-futures options positions are margined according to the SPAN method (Standard Portfolio Analysis of Risk), which determines the potential loss of the position, based on different scenarios in the bond-future price, time, and volatility. It's similar to portfolio margin for equity accounts.

Picking strategies:

The strategies you use for bond futures and options can be based on probability and volatility, just as you might use with your equity option strategies. Bonds just offer a trader additional trading opportunities, particularly around economic events like Fed meetings and employment reports. You may be long-term bullish or bearish on bonds if you expect interest rates to decrease or increase over time, based on U.S. economic activity, but the 30-year future typically makes enough large price changes up and down daily and weekly to accommodate scalpers and swing traders looking to capture shorter-term moves. But, of course, past performance is not a guarantee of future performance. Options traders often use defined-risk strategies like verticals and iron condors to speculate on bonds going up, down, or sideways. It's not possible to enter spread orders for bond-futures options yet, so you'll have to leg into them which will trigger additional transactions costs. Keep your position size small while you're learning to trade bond-futures options. They're actively traded with tight bid/ask spreads, but bonds can move sharply in a matter of minutes, and you don't want to be caught legged out on a position.

Whether you're ready to start trading in the bond arena, or just want to first be a spectator, get familiar with the bond trading tools on the TD Ameritrade platforms, and you might be teaching your financial planner a thing or two at your next meeting.