Unveiling the Mysteriousness of NOB Spreads

September 19, 2011 4:42PM CDT

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.


Spread Trading Guide


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

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This material has been prepared by a sales or trading employee or agent of RJO Futures and is, or is in the nature of, a solicitation. This material is not a research report prepared by RJO Futures Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.