Adding on to the yield futures discussion from yesterday, Pete shows how to use analyst predictions and the treasury markets to make infamous trades like the NOB spread. Also we learn how to look at curves and make market assumptions.
The NOB Spread
The Notes Over Bonds Spread (also called the NOB Spread) is the difference between the yields on the 30-year bond and the 10-year bond.
Many traders use the NOB spread as a signal of where interest rates may be headed and helps to gauge the current shape of the yield curve.
The Yield Curve - Steepening/Flattening
Remember, yields have an inverse relationship to prices. When yields are down, prices on Treasuries will increase and vice versa.
Bond yields are charted over varying time frames and maturity levels, and the “steepness” and “flatness” in the curves can indicate potential changes in interest rates as well as economic expectations. Typically, strong economies have steepening yield curves - the longer maturity yields increase more than the shorter maturity yields. Weak economies have flattening yield curves - the longer maturity yields decrease more than the shorter maturity yields.
Picking A Strategy Based On The Yield Curve
Determining a proper trade for a NOB spread is fairly simple depending on if you expect the curve to flatten or get steeper.
If you expect it to flatten, you want to sell the NOB spread. To do this, you sell the front leg (the shorter maturity leg), and buy the back leg (the long term maturity leg).
If you expect the curve to get steeper, you buy the NOB spread. Meaning you buy the front leg and sell the back leg.
Dollar Value Of A Basis Point
The risk measure that is used for yield curve trades is called the dollar-value of a basis point (or DV01). If you are familiar with stock options, you can think the dollar-value of a basis point as you bond’s delta. With a spread, the back leg will always have a greater DV01 value than the front leg will.
To create a DV01 neutral position (essentially the same as creating a delta-neutral options strategy), you must calculate a hedge ratio.
Calculating A Hedge Ratio
To calculate the hedge ratio, you need to know the DV01 of the two different futures contracts. Rather than do it by hand, we recommend using the CME Group’s spread calculator.
Once you get the DV01, then you can create the hedge ratio. Let’s calculate the hedge ratio for the NOB spread.
1 /ZN (10-year note w/ FV at maturity of $100,000. DV01=77.73
1 /ZB (30-year note w/ FV at maturity of $100,000. DV01 = 216.37
Once you have the DV01 values, you just divide the 10-year DV01 by the 30-year DV01.
(77.73/216.37) = .35 (which we will round down to about 3).
Setting Up A NOB Spread - Yield Curve Steepening
If you believe that the yield curve will steepen, then you will want the buy the 10-year notes and sell the 30-year notes using the hedge ratio calculated above.
In this instance, we would:
- Sell 1 /ZB contract
- Buy 3 /ZN contracts
By buying three 10 year note contracts and selling one 30 year note contract, you are effectively creating a DV01 neutral position.
Strategies: NOB (Notes Against Bonds) Spread
Products Discussed In This Episode: /ZB, /ZN
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