A common way to hedge your risk against your fixed income portfolio is to use the Treasury bond over the Treasury note spread. This is commonly known in the futures industry as the NOB spread.
Most investors are well aware of the fluctuation in the yield curve and how it reacts to the Federal Reserve’s policy decisions. There is not a day that goes by without a newswire mentioning the stagnant economic outlook in the U.S. and abroad. Right now the lending rates are at the lowest levels they have been in years; therefore trying to earn an extra buck investing in fixed-income instruments is like treading water as the waves continue to push you back further and further into the 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 t-note and sell the 30yr t-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 $3900. To buy the NOB, the initial margin is $2400. 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. This may run contrary to what the Fed has been saying, which is that they intend to keep interest rates down until mid 2013. And many market participants are expecting the Fed to announce “Operation Twist” at this week’s FOMC. The Fed strategy, in lieu of another round of quantitative easing, calls for reshuffling of the Feds debt portfolio. Buying the long end of the curve and selling the short end is the expected course. This makes sense since the Fed has vowed to keep long-term interest rates down.
It has also been circulated in the last few days that Bill Gross of Pimco has dramatically increased the duration on his $50 billion T-bond portfolio after having been bearish T-bonds for several months. In addition, Bloomberg notes that “The 20 primary dealers, which trade directly with the Fed, held $15.1 billion of Treasury Securities due in more than one year as of Sept. 7th, up from a $75 billion bet against the debt on May 6th, Fed data show.” A $90 billion reversal to the bullish side!
Make no mistake; buying the NOB is a contrarian play. The old axiom “buy the rumor, sell the fact” may come to fruition here. The Fed has telegraphed its intentions and market participants have acted accordingly. In other words, “Operation Twist” could already be priced into the marke
Series 3 Licensed
Senior Market Strategist
After earning a degree in political science and philosophy at Loyola University, Tarik put his education to work by taking a job as a runner on the floor of the Chicago Board of Trade. His initial exposure to futures began in the grain room, where he ran orders from the order desk to the brokers in the pit. Surviving the dog eat dog world of the pits he then went to the phones as a clerk, interacting with clients on a daily basis. Within the year he was hired at Shatkin, Arbor, Karlov as an arb clerk in the bond room. There he thrived on the fast pace and pressure filled environment of the floor and was rapidly promoted to Bond desk manager for SAK, staying in that role from 1996-2003. He became a member of the CBOT in 2000 and was a member for more than 5 years, honing his skills while working with some of the most successful traders in the business. Tarik has traded independently as well as proprietorially since 2000: focusing on treasury bonds, metals, grains and crude oil. He also has experience with various option strategies on the buy, as well as the sell side. Tarik does his utmost to represent his clients with the knowledge and experience that he has built.