History Is Repeating Itself: Get Ready for a Long Dry Spell

Abstract

Ramzi Ben-Abdallah is associate professor of finance at UQAM School of Management, Montréal. Michèle Breton is professor of management science at HEC Montréal.T he US Treasury bond futures contract, 1 one of the world's most actively traded futures contracts, is used extensively to hedge long-term interest rate risk. This contract calls for the delivery of $100,000 of a long-term government bond. The notional underlying security is currently a T-bond with a maturity of 15-25 years and a coupon rate of 6%. Because the notional bond is hypothetical and not necessarily traded in the marketplace, the exchange offers short traders the option to choose which issue to deliver among a set of deliverable bonds (the delivery basket). A system of conversion factors is used to adjust for the coupon rate of all the deliverable bonds with respect to the hypothetical reference bond. Because of the imperfection of the conversion factor system, which is based on bond characteristics and does not account for changes in the yield curve, not all eligible grades are equal for delivery to US T-bond futures, and short traders generally find that some issues are more profitable to deliver than others. The security that is the most advantageous for the short trader to deliver is called the "cheapest to deliver" (CTD). 2 A bond's CTD status depends on not only its characteristics (coupon rate and term to maturity) but also market conditions-namely, the market price of the various grades, which is directly related to the yield curve of Treasury securities. Therefore, CTD status is not attached to a particular bond; it varies from contract to contract and even from day to day during the trading period of a particular contract. In the US T-bond futures market, short traders are allowed to deliver on any business day in a delivery month, and thus a variety of bonds may be delivered to T-bond futures contracts. The possibility of delivering any bond within a large delivery basket at any time during the month is meant to alleviate the demand for a single issue and to avoid congestion, or market squeezes.In this article, we recall an episode in the history of US T-bond futures when the concurrence of several conditions gave rise to a progressive entrenchment of the CTD bond over December 1994-December 1999. This entrenchment of the CTD bond had negative repercussions on the futures and bond markets. An analysis of this episode should be enlightening given that a similar uncommon conjunction of conditionsThe recent disappearance of a five-year maturity gap from the set of bonds deliverable to the Chicago Board of Trade Treasury bond futures has resulted in a distinctive configuration, whereby a single T-bond will have the shortest remaining maturity in the delivery basket of bonds for a five-year period. This situation would be inconsequential were three other conditions not simultaneously present, ensuring that this single bond will probably be the cheapestto-deliver bond over the next five years. We show that a similar alignment of conditions ...