Credit futures provide the market with new tools to manage investment grade (IG) and high yield (HY) credit exposure. This article examines how well the three credit futures contracts track their underlying indices as well as the richness/cheapness of the futures compared with the spot prices of the underlying indices. For all three contracts we observe that the futures returns closely track the underlying index returns and that the futures are generally fairly priced compared with the underlying indices.
Futures closely track the underlying indices
Figures 1, 2, and 3 demonstrate that daily movements in futures settlement prices tend to track daily movements in the underlying indices.
Figure 1: Investment Grade Futures and Index Settlement Prices
Figure 2: High Yield Futures and Index Settlement Prices
Figure 3: Duration-Hedged Investment Grade Futures and Index Settlement Prices
This can also be seen more precisely in the low tracking error between futures and the underlying indices, as shown in Table 1 [1].
Table 1: Futures tracking error
|
Futures |
Underlying Index |
Daily Tracking Error (Annualized) |
|---|---|---|
|
IQB |
LUACTRUU Index |
1.42% |
|
HYB |
LHVLTRUU Index |
2.41% |
|
DHB |
I30287US Index |
2.73% |
|
* Last updated 11/4/2024 |
||
The futures are generally fairly priced
Figures 1, 2, and 3 show that while futures prices tend to move with the index, there is a basis between the two. This is expected since the futures price must account for the net cost of holding the futures position between now and expiry, i.e., the cost of carry. This basis narrows as the futures approach expiry and widen once the futures roll from one contract month to the next.
The net basis can be measured as the difference between the futures price and the fair value futures price. To calculate the fair value futures price, the spot price of the underlying index needs to be adjusted to account for cost of carry. For these contracts, cost of carry represents the financing cost associated with purchasing the index today (i.e., purchasing the basket of bonds that make up the index) financed at prevailing short-term rates and holding the index until futures expiry:
Where R is the prevailing short-term rate[2]. Therefore, the futures net basis can be calculated as:
Figures 4, 5, and 6 show the net basis over time for each futures contract as a percentage of the fair value futures price. A net basis of zero indicates that the futures are fairly priced relative to the spot price of the underlying index and prevailing financing rates. A negative (<0%) net basis indicates the future is trading at a discount to the fair value, and is considered “cheap”. A positive (>0%) net basis indicates the future is trading at a premium to the fair value, and is considered “rich”.
Figure 4: IQB Net Basis
Figure 5: HYB Net Basis
Figure 6: DHB Net Basis
Figures 4, 5, and 6 along with Table 2 show that the net basis generally fluctuates around zero for all three contracts.
Table 2: Futures Net Basis Descriptive Statistics
|
Futures |
Mean |
Std Dev |
Min |
Max |
|---|---|---|---|---|
|
IQB |
-0.09% |
0.17% |
-0.44% |
0.28% |
|
HYB |
0.02% |
0.20% |
-0.43% |
0.47% |
|
DHB |
-0.10% |
0.21% |
-0.64% |
0.37% |
|
* Last updated 11/4/2024 |
||||
Deviations from fair value may be driven by imbalances in demand for long and short positions, i.e., excess demand for short futures positions may push futures prices down. There may exist barriers to arbitrage such as transaction costs that prevent arbitrageurs from bridging such imbalances. In addition, the net basis calculation is sensitive to the inputs used to calculate futures fair value and these inputs are based on assumptions that may not always hold, e.g., financing rates based on the SOFR OIS curve may not be representative of the true financing costs faced by arbitrageurs.
Conclusion
In the first few months of trading, CME Group’s Credit futures have closely tracked their underlying indices and have generally been fairly priced relative to them. This demonstrates their utility in helping market participants manage exposure to the U.S. corporate bond market.
Resources
[1] Annualized tracking error is calculated as the annualized standard deviation of daily excess returns for futures compared to the underlying index. Tracking error calculations are updated daily in the Credit Futures Analytics tool
[2] In the below charts, the fair value futures price was calculated using linearly interpolated rates from the USD SOFR OIS curve.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
