In an interview with CNBC, bond maven Bill Gross said, “If 2.6% is broken on the upside, a secular bear bond market has begun. The 2.6% level [in 10-year Treasury yield] is much more important than Dow 20,000; much more important than $60-a-barrel oil; much more important than dollar/euro parity at 1.00. It is the key to interest rate levels and perhaps stock prices in 2017.”
When interest rates rise bond prices drop. When interest rates fall bond prices rise. Let’s look at a 10-year note with a coupon rate of 3% and a face value of $100,000. The coupon rate is usually the same as the market rate at its inception. One year later, the market rate is 2%. With nine years remaining, the price of the note climbs to $108,200. Since the coupon rate is a full percentage point higher, it makes sense that it would increase in value.
Now let’s say that instead of interest rates dropping a point, they rise by one point to 4%. With nine years remaining the price of the note drops to $92,500. Since the coupon rate is a full percentage point lower than what the market currently bears, it makes sense that it would drop in value. With coupon rates at historically low rates the interest rate risk is very high. Generally speaking the longer to maturity, the higher the interest rate risk unless rates are at historically high levels. Traders have been anticipating a bond bubble for the last six years but it hasn’t happened yet. Timing is everything.
As recently as June 27, 2016, the yield on the 10-year note was 1.46%. In September of 1981, the 10-year yield was above 15%. On Jan. 12, 2017, it stands at 2.36%. On Dec.16, 2016, the yield hit 2.6% but did not surpass it. The steady upward trend in the yield has momentarily halted. Or is it part of a reversal in a correction? There is a lot more room to the upside for the yield but they’ve been saying that in Japan for the last quarter century.
What strategy would be appropriate now? Let’s look at a slightly bullish spread in options on futures on Jan. 9, 2017. You would buy five 10-year note February 2017 calls with 18 days until expiration and sell five 10-year note Week 3 January 2017 calls with 11 days until expiration. This is combining a time value spread with a vertical spread, sometimes called a diagonal spread.
The short calls expire a week before the long calls. The long calls are purchased for 32/64ths and the short calls are sold for 19/64ths. The March futures were trading at 124-13 at the time. That is three full ticks shy of the 124.50 strike price. There are 32 ticks for one point at $31.25 per tick. Options ticks are half that. That means that one point is $1,000. Each long call would be a $500 debit. Each short call would be a $296.875 credit resulting in a net debit 13/64ths ($203.125) per spread.
With a five-lot spread, the total debit is $1,015.625. That is the maximum possible loss. At expiration the spread will go out worthless until it trades above 124-24. This would occur if no adjustments are made and the 10-year note futures settle below 124-24 on the fourth Friday in January. The breakeven point is 124-30.5 (see “profit target”). If you were to sell the February 2017 calls in lieu of the Week 3 January 2017 calls the debit for the spread would then come in lower at 8/64ths.
Options that are closer to expiration decay at a more rapid rate. That is one reason to sell the calls that expire a week earlier. If the futures head straight down then you would have been better off selling the later-dated options for a higher premium. Let’s say that the futures trade above 125-00 and no adjustments are made, then the short calls would be assigned and you would be short five futures at an effective price of 125-01.5 (124-24+095). That would result in a long synthetic put at 29/64ths ($453.125). An adjustment that you could make would be selling the 125 time value spread for 9/64ths thereby converting your spread into a long February 2017, 124-75/125-00 vertical spread established for an effective debit of 4/64ths with a maximum value of 16/64ths at 125-00 or above.