Unveiling the Mysteriousness of NOB Spreads

September 19, 2011 9:33AM CDT

Updated August 31, 2017

One of the ways investors tend to hedge their risk is to use what is known as the NOB spread. What is the NOB spread? The NOB spread, also known as Notes Over Bonds Spread, is the difference between a 10-year Treasury note and a 30-year Treasury Bond.

Most investors are aware of the fluctuation in the yield curve and how it reacts to the Federal Reserve’s policy decisions. Investors often receive news about economic outlooks in the United States and overseas. Lending rates, whether low or high, lead investors to increase the value of their portfolios using fixed-income instruments. However, since interest rates are impacted by stagnant or growing economies, this can often feel like treading water in a rough ocean.

This leads to a very basic principle of how rates affect short-term and long-term instruments. Typically, when the short-term yield rises relative to the long-term, the yield curve flattens. While on the other hand, when the short-term yield pullbacks more than the long-term yield, the curve steepens. If we see the yield curve beginning to steepen, we recommend buying the NOB spread (buy 10yr Tt-note and sell the 30yr Tt-bond). The rule of thumb suggests we sell the spread when we anticipate the yield flattening, using the shorter-term instrument as the indicator of which direction you intend for the market go (buy the 30-yr T-bond and sell the 10-yr T-note).

To explore this one step further, to position yourself for a bearish move in the T-bonds is to buy the NOB (Note over Bond) spread. The trade would entail buying the Treasury note (ZN) and selling the Treasury bond (ZB). Typically, there is a ratio related to this spread; 1.6 T-notes to every 1 T-bond. However, to capitalize on a T-bond correction, keep the ratio at 1:1. This will add a little octane to the trade should T-bonds sell off. Keep in mind from a risk management perspective that buying the NOB spread should also be less risky than selling the T-bond outright. This is because if T-bonds rally rather than sell off, one can typically count on the 10-yr T-note rallying also, but at a lesser rate. Thus, the loss on the spread will be less than being short the T-bonds outright. This is also reflected in the margin for the trade. Taking a short T-bond position will take an initial margin of $3300. To buy the NOB, the initial margin is $2352. A typically indicator, less margin usually indicates less risk.

Essentially, buying the NOB would create a position that would benefit from a steepening of the yield curve. If the 30-yr T-bond sells off, long term interest rates will go up, pushing the long end of the curve higher. The Federal Open Market Committee (FOMC), a 12-person board, meets eight times annually and determines whether the interest rates will increase, decline, or remain the same for a period of time. Generally, investors and other market watchers will have an estimate of what the Fed will do with rates and try to make their investments based on those assessments. For example, if there is a determination that quantitative easing is needed, the Feds will begin moving their debt portfolio around. Assuming the Fed’s position is that long-term interest rates will remain low, the investor would buy the long end of the curve, and sell the short end.

It is important to understand how and why the NOB spread is used. Traders and investors typically use this spread to determine economic expectations. They also use the NOB spread to shape the yield curve, a representation of the yields for different maturities.

To understand the mechanics of these trades, it is important to understand what happens to the spread of short-term rates when long-term rates narrow. This often means we are in a low inflation environment and there is little demand for long-term interest rates, which are typically higher. This also occurs when credit is tight; for example, banks making more demands on borrowers, making it harder to get a loan. These factors, along with quantitative easing, are all signs an investor would sell the NOB; buy the 30-year bond, and sell the 10-year note. Remember, in general, bond yields tend to fall relative to note yields.

NOB Spread - 10-Year T-Note - 30-Year T-Bond

NOB Spread

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