One way market participants can manage interest rate risk is by using T-Bill futures spreads.

Trading intercommodity spreads involve simultaneously entering into two futures positions in a single order – one long and one short. Since both the SOFR rate and T-bill yields are used as benchmarks for short-term interest rates, the intercommodity spread between them is especially interesting for many traders. 

The spread price is calculated as the Three-Month SOFR futures contract price minus the 13-Week T-Bill futures contract price. This spread price will often, but not always, be a negative number – a consequence of the fact that the SOFR futures contract is based on a money-market rate, whereas the T-Bill futures contract is based on a discount yield.

The December 2023 T-Bill futures final settlement price is determined by the highest accepted discount rate of the 13-week T-bill auction on Monday, December 18th, 2023. The bills issued in this auction will mature three months later, on Thursday, March 21st, 2024.

Meanwhile, the December 2023 SOFR futures final settlement price is determined by the daily compounded SOFR rates between Wednesday, December 20th, 2023 and Wednesday, March 20th, 2024, thus aligning closely with the 3-month rate exposure that T-Bill futures provide.

Consider a portfolio that holds a long position in cash T-bills hedged with a short position in SOFR futures. Despite being partially hedged, this portfolio is exposed to asset swap risk because T-bill yields may respond differently to external market conditions compared to SOFR rates.

To mitigate this risk, a market participant can use a SOFR/T-Bill futures spread to manage potential differences between the two rates. Market participants can also roll the spread trade forward at expiry if they wish to remain hedged.

Say a portfolio is long Treasury bills with a DV01 of $100,000, and short SOFR futures with the same DV01 of $100,000 to offset some of the interest rate risk in the portfolio. This portfolio is still at risk of losses if T-bill supply suddenly surges or drops. To further manage this risk, the portfolio manager could implement an overlay strategy using a SOFR/T-Bill futures spread.

Since both SOFR and T-Bill futures contracts are defined by the IMM index, with a DV01 of $25 per basis point, the portfolio manager could hedge their $100,000 risk by executing 4000 SOFR/T-Bill futures spreads. Shortly after, suppose the supply of U.S. T-bills increases and T-bill yields rise by five basis points. This leads to a decline in T-Bill futures prices. Additionally, assume the SOFR yield curve increases by only two basis points.

Without the overlay, the original portfolio’s net position would have lost $300,000, as the payout for the SOFR futures hedge would only compensate for $200,000 of the total $500,000 loss incurred by the portfolio of T-Bills. With the SOFR/T-Bill futures spread overlay, however, one can expect to be much more closely hedged. 

Given that T-bill yields rose five basis points, and the SOFR curve only gained two basis points, the spread between both would have theoretically increased by three basis points. The 4,000 contract overlay, at $25 per basis point, would have compensated the investor for the remaining $300,000.

When it comes to navigating interest rates fluctuations, SOFR/T-Bill futures spreads provide one way to manage this risk. For more information, visit cmegroup.com/tbillspreads.