U.S. Treasury-issued bonds, known as T-Bonds, are considered one of the safest investments available, but they are not without risk. If interests rates rise after you purchase a T-Bond, the price of the bond will fall — this is known as interest-rate risk. If you have investments that can lose value when interest rates change, you can hedge against potential losses using T-Bond futures.
Hedging acts an effective method for reducing risk and ensuring the highest possible return in the face of market uncertainty.
Basics of Treasury Bonds
New T-Bonds are issued quarterly by the U.S. Treasury in denominations that are multiples of $100. They pay interest, called the coupon, semi-annually. The initial price of a T-Bond is determined by a public auction and is based on a bond’s coupon compared to interest rates of competing bonds. If a T-Bond’s coupon is equal to current interest rates, its price will be par, which is the redemption, or face, value of the bond at maturity.
Bonds with relatively high coupons sell at a premium above par; low-coupon bonds are issued at a discount below par. Once issued, T-Bonds trade in secondary markets such as the New York Stock Exchange. An already-issued T-Bond’s price will decline if interest rates rise because buyers will need to be enticed by lower prices to accept a relatively low coupon. The reverse is true when interest rates fall.
Exploring Futures Contracts
A futures contract obligates the buyer to purchase a specified quantity and quality of underlying commodity or financial instrument to be delivered by the seller on a future delivery date for a price set in advance. Highly standardized futures contracts trade on futures exchanges. Traders open accounts with licensed brokers to trade futures and these accounts allow traders to enter into contracts with only small deposits, called margins. Margin requirements usually range from 2 to 10 percent of a contract’s value.
Understanding T-Bond Futures
T-Bond futures trade on exchanges such as the CME Group. The underlying instrument for a CME T-Bond futures contract is a T-Bond with a $100,000 face value. The buyer of the contract is called the long position and profits when the price of the underlying bond, and hence the value of the contract, increases.
The seller, or short position, benefits from falling prices. The margin deposit on a T-Bond contract may change over time but is usually less than $4,000.
Exploring T-Bond Hedging
Traders who have positions in long-term financial instruments that are sensitive to interest-rate changes can take offsetting, or hedged, positions using T-Bond futures. Because of the low margin requirements, a futures trader can hedge a $100,000 bond position for only $4,000 or less, which makes hedging very easy and cost-effective.
A hedger would sell a futures contract to offset interest-rate risk on bonds in his portfolio. If interest rates rise, the price drop of his bond portfolio would be offset by a gain in the value of his short position in T-Bond futures contracts. A hedge can be removed at any time: the long position can sell the T-Bond futures contract to close the position, and the short position can buy back the contract to retire it.
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