Bond and beyond
The opinions expressed in this report are those of Inspirante Trading Solutions Pte Ltd (“ITS”) and are considered market commentary. They are not intended to act as investment recommendations. Full disclaimers are available at the end of this report.
Highlights
Introduction
U.S. Treasury securities are debt obligations issued by the Department of the Treasury to finance government spending. Backed by the full faith and credit of the U.S. government, they are considered among the safest investments available, reflecting the strong trust placed in the government's ability to meet its obligations. These securities come in various maturities and structures, designed to meet different investment needs:
- Treasury Bills (T-Bills) are short-term securities with maturities ranging from a few days to one year.
- Treasury Notes (T-Notes) are medium-term securities with maturities of 2, 5, or 10 years.
- Treasury Bonds (T-Bonds) are long-term securities with maturities of 20 to 30 years.
The U.S. Treasury market forms the cornerstone of the global financial system, offering a combination of safety, liquidity and benchmark status that few other instruments can match. While some investors may perceive treasuries as being primarily for institutional participants compared to equities, commodities or forex, a deeper understanding of these instruments becomes increasingly essential for investors in today's complex markets.
Treasuries are far more than just debt instruments. One of their most critical roles is serving as the default risk-free asset against which other investments are measured. This influence extends beyond U.S. borders, affecting borrowing costs, currency valuations and global capital flows. Treasury yields serve as reference rates for a wide range of financial products, impacting areas of everyday life such as mortgages, corporate bonds, credit cards and student loans.
Furthermore, the Federal Reserve (Fed) conducts open market operations with Treasuries to manage the money supply and influence short-term interest rates, thereby guiding the economy toward its dual mandates of maximum employment and price stability.
In times of economic uncertainty, Treasuries are often the asset of choice for investors seeking safety, as seen during the 2008 financial crisis and the COVID-19 pandemic. Their status as a safe haven, along with their inverse correlation to riskier assets, has also contributed to the widespread use of the 60-40 portfolio strategy, which typically allocates 60% to equities and 40% to treasuries for diversification and enhanced risk-adjusted returns.
In addition, Treasury yields serve as more than just indicators of government borrowing costs; they also reflect market expectations regarding future economic growth, inflation, and monetary policy. For instance, a rising yield on the 10-year Treasury note often signals expectations of stronger economic growth and higher inflation, prompting shifts in investors' strategies and asset allocations.
Figure 1: U.S. CPI YoY vs. U.S. 10-year Treasury Yield (Monthly)
Understanding Treasury futures
Unlike purchasing physical bonds, trading Treasury futures offers investors flexibility and leverage. These instruments enable a wide range of strategies, including hedging exposure to interest rate risks, speculating on interest rate movements, and managing yield curve shifts, all without transacting in the physical bond market. Treasury futures are among the most liquid financial instruments worldwide, and their standardized nature simplifies the trading process compared to cash bonds.
While the complexities of bond delivery mechanisms, cash bonds, conversion factors and cheapest-to-deliver (CTD) options are beyond the scope of this article, we will focus on trading Treasury futures and inter-commodity spreads. For readers interested in these advanced topics, CME Group provides detailed materials.
Why do bond prices and yields move in opposite directions?
The prices of bonds are largely determined by interest rates, the bond issuers’ credit quality, duration of the bonds and the supply/demand in the market. A fundamental principle of fixed-income markets is the inverse relationship between bond prices and yields. This concept can be explained simply: When interest rates rise, newly issued bonds offer higher coupon rates (i.e., higher interest payments to bondholders). As a result, existing bonds with lower coupon rates become less attractive, driving their prices down to align their yields with the new, higher-rate bonds. Conversely, when interest rates fall, bonds with higher coupon rates become more valuable, increasing their prices.
Bond yield refers to the income return (from coupon payments) relative to the price paid for the bond. For example, suppose an investor purchases a bond with a face value of $1,000 and an annual coupon payment of $50 (coupon rate: 5%). If he buys the bond at its face value, the bond yield is 5%. However, if he purchases the same bond at a discounted price of $900, the bond yield increases to approximately 5.56% because he is receiving the same $50 annual payment on a smaller investment. Conversely, if he pays a premium price of $1,100 for the bond, the bond yield decreases to about 4.55%. This illustrates how the bond's yield varies inversely with its price. A higher bond price results in a lower yield, and vice versa.
CME Group Treasury futures derive their value from the prices of the underlying Treasury securities. Investors who expect yields to rise may express their views by selling Treasury futures, given the anticipated decline in bond prices. Conversely, if yields are expected to fall, investors may buy Treasury futures to capitalize on the corresponding price increase. Figure 2 shows the long-term inverse relationship between the 10-year T-Note futures price and the U.S. 10-year yield.
Figure 2: 10-year T-Note futures vs. 10-year Yield (Monthly)
Understanding duration
Beyond the inverse relationship between bond prices and yields, it is also essential to understand how bonds with different maturities respond differently to interest rate changes. Duration measures a bond's sensitivity to interest rate fluctuations, estimating the percentage change in the bond's price for a 1% (100 basis points) change in rates.
A higher duration indicates greater price sensitivity. For example, longer-maturity bonds like the 30-year T-Bond have higher durations compared to shorter-term bonds like the 2-year T-Note. This is because the formers’ cash flows are further in the future, making their present value more affected by changes in interest rates. The longer the time horizon, the more volatile the bond prices become, as amplified by more potential rate changes through the course.
It's important not to confuse duration with maturity. While maturity refers to the time remaining until the bond's principal is repaid, duration measures how sensitive the bond's price is to changes in interest rates, taking into account all coupon payments and the time value of money. Two bonds can have the same maturity but different durations if they have different coupon rates or payment structures. Duration provides a more comprehensive measure of interest rate risk than maturity alone.
Treasury inter-commodity spreads (ICS)
The yield curve
Having established the importance of bond maturities in pricing, we turn to an essential concept – the yield curve, which plots the interest rates of bonds with equal credit quality but differing maturities, typically U.S. Treasuries. The yield curve illustrates the relationship between short-term and long-term interest rates, providing insight into market expectations for economic growth, inflation and monetary policy.
Figure 3: U.S. Treasury yield curve
Under normal economic conditions, the yield curve slopes upward, indicating higher yields for longer-term bonds. This reflects the risks associated with time, such as inflation and uncertainty about future conditions. Investors demand higher yields to compensate for these risks. However, the curve can flatten when short- and long-term yields converge or invert when short-term yields exceed long-term yields – often a reliable predictor of economic recessions. The cases in early 2000s, 2007, 2020 and 2023 are prominent historical examples.
Figure 4: U.S. 2y10y yield spread
