Bond Trading Is More Profitable Than You Think… Like, Way More.
If you thought bonds were stale and boring — I’ve got a bridge to sell you.
Bonds.
You know, that boring asset class known for its stability, predictability, and the tendency to occasionally cause financial meltdowns?
Well, that might be true if you’re just a regular investor buying them for your kids’ college fund. However, if you’re running a bond fund or trading desk with the goal of generating higher returns, then bond trading can be extremely profitable:
Details on exactly how these rate traders make so much is opaque (for good reason), but today, we’ll add some clarity and show you exactly how it’s done.
To understand how this works, it will be best if we put ourselves in the shoes of a rates trader:
Pre-Trade
It is 2021 and you are an interest rate trader at a fund that holds bonds. Your portfolio consists of $1 billion of treasury and municipal bonds, with an average maturity of 5 years. However, rumors begin to circulate on Wall Street that next year, the Fed will need to start raising interest rates:
You aren’t yet sure about what this will mean for your PnL, so you do some quick math:
Estimated Bond Price Change = -(time_to_maturity) * change in yield
Estimated Bond Price Change = -(5) * .05 = -.25
Portfolio Dollar Change = Bond Price Change * Face Value
Portfolio Dollar Change = -.25 * $1,000,000,000 = -$250,000,000
If the fed ends up raising interest rates, your short-term estimated loss will be -$250 million! While you would only experience this loss if you sold it early, you are at a hedge fund. This means that it’s a very real possibility that a client may have a need to cash-out early, forcing you to realize some of those losses.
You can’t let that happen.
So now, you have two objectives:
- Hedge out the risk for safety
- Take a position that will profit if rates end up at that level
Hedging
There are numerous ways to hedge out this risk, but the cheapest and the fastest will be to use futures contracts:
Your portfolio mainly consists of bonds that mature in 5 years, so the best contract will be the CME 5-Year T-Note Futures. This contract acts as a proxy for the average interest rate on a 5-year treasury bond, so if rates go up, the price of the future will go down accordingly — conversely, if rates go down, the price of the future will go up accordingly.
We want to be short this contract since our risk is interest rates going up, so we first calculate the proper hedge ratio.
Hedge Ratio = Risk Exposure / Contract Size
Hedge Ratio = 250,000,000 / 100,000 = 2,500 contracts
So, in order for us to be hedged from the risk of interest rates going up by 5%, we will short 2,500 contracts. If rates go up by exactly 5%, our short-term PnL will be $0 — so if, for any reason, we need to sell some bonds early, we can do so since the loss will be offset by the profit on the futures position. Additionally, if we hold and keep rolling the short position, then when the bonds mature, we will reap a massive profit from the futures trade.
Now that we’re hedged, let’s focus on making a profit.
Trading
As with hedging, there are countless ways to express our view, but since our goal is to make a profit, we want the option that will give us the most bang for the buck. Since we are a bond fund, it is also important to stick to our objectives and choose a product that will deliver a predictable cash flow.
So, we’ll go with an interest rate swap.
An interest rate swap is a contract where you and the counterparty (e.g., a bank, prime brokerage, different fund) exchange cash flows.
To better understand this, let’s say we enter into a swap with Morgan Stanley:
For the next 3 years, we will pay Morgan Stanley a fixed interest rate of 3% of the contract size. In exchange, they pay us 1% plus a rate tied to the fed-funds rate, which at the time of this trade, is around 0.5%.
We will commit $10 million to this swap, so if rates remain flat, we will pay Morgan Stanley $300,000 (3%), and they will pay us $150,000 (1.5%). Clearly, this is very advantageous for Morgan Stanley as they bank an extra $150,000 every year.
However, if our prediction is correct, then while we still pay Morgan Stanley the $300,000 annually, they now pay us $600,000 annually since their fixed rate of 1% stays the same, but the floating fed funds rate went from 0.5% to 5%, for a total pay of 6%.
At that point, we would essentially double our money for each year that the swap remains active.
Now, if interest rates rise to 5%, we will be hedged on the bonds we already hold, and we’ll make a substantial profit on the swaps we bought. Additionally, we will create a major profit on the futures bet since we are short 2,500 contracts. If rates stay flat, we take a small loss on the payments we make for the swap, but we are still hedged with the futures contract.
This setup was seen all throughout 2021/2022, with different combinations and nuances applied on each desk. Some funds used options to make their bets/hedge, some used ETFs.
But nonetheless, you can now see how it goes from being just a boring, old asset class to a world-class profit machine.
If this article piqued your interest, you’d definitely enjoy some of my other posts just like this one:
- Kick-Off! Quasi-Arbitraging NFL Markets [Code Included]
- No One Model Should Have This Much Power.
- I Found A Way to Arbitrage Your 401(k)
Happy trading! 😄
