Bond Basis Trading
Is there anything to do in this? A few years ago during Fed QE seems net basis was close to 0 but slightly positive, as the switch option was worthless due to CTD mostly entrenched as lowest duration issue in deliv supply. Low vol reduced value of any timing (e.g. wild card) option as well.
But with the net basis trading negative ticks it there anything to do? My intuition is mostly no. Fast money accounts know it's a balance sheet intensive trade (which keeps CTD cheap to futures), and with interdealer o/n GC trading near IOER (50 bps), even an implied repo of 85-90 bps on the Ultra bond contract would require quite a bit of size to make a few ticks.
Can anyone lend more color? Couldn't a fast money acct put the long basis trade on as a cheap option, fund at o/n GC and close it out of the net basis reverts to 0 and pick up potential MtM gain?
Has embedded optionality changed at all? Switch still seems mostly worthless. Wildcard on long basis with conversion factor NY time) to be worth exercising.
Thanks
The world has changed and it has nothing to do with the switch optionality. Due to the regulatory changes, balance sheet has become significantly more expensive across the industry. Furthermore, the volatility that scarcity of balance sheet capacity creates in various bond mkts has increased significantly. Both of these things imply that there's really nothing to do. In fact (and I haven't looked at it closely recently), if you were to regress net basis (or whatever) vs, say, 30y spreads, I suspect you might find that it's either fair or maybe even not cheap enough.
Can you explain choice of regressing net basis vs. 30y spreads? Is this 30y swap spreads or 30y invoice spreads? I assume you're looking at rich/cheap adjusted for some metric of balance sheet use and cost of capital.
Practically, I assume you need intraday data to better capture where one could've actually locked in the basis. Bloomberg seems to track the historical closing prices, which I'm not convinced is necessarily the level where the typical long could enter into intraday.
I am just throwing some random ideas out there...
It appears, based on recent developments, that the long ends of various curves (USTs, gilts, etc) are suffering particular pain due to the reduction in the system's balance sheet capacity. Well, at least that's my theory, anyways. I believe that the root cause behind the cheapening of bond basis is the same, so I am proposing an experiment that may provide some corroboration. Obviously, any such correlation could well be spurious and all the other caveats apply.
Given the nature of the experiment, you would need to use cash, rather than the invoice spread. As to the basis, I dunno, I have stared at it intra day and I don't see any monumental fluctuations that would suggest that closes are not representative.
When I run DLV on WNH6 and click on the CTD (4.375 5/41), I see the close-to-close implied repos swing back and forth between around +100s to around -100 to -200 bps in the past week. Intraday feed would suggest a marking issue at close (perhaps just on my end). That said, FVH6 close to close looks close to what I had been seeing intraday.
Ran some year-to-date regressions of FVH6 CTD Implied repo / Net Basis against 30y spreads and against o/n avg. GCF repo. The net basis vs. 30y spreads and net basis vs. GCF regressions show current net basis is slightly rich vs. model (predicts -1.3 ticks), which I expected given the nominal richening in the net basis since start of the thread. But Implied repo vs. GCF shows current implied repo is slightly cheap vs. model (predicts 59 bps). Regressing implied repo vs. GCF gives a much higher R^2 (0.80) and greater significance via F-test @ 95% confidence lvl compared to regressing net basis vs. 30y spreads or vs. GCF (R^2 = 0.31).
I think these results do suggest we're pretty close to model "fair value" in each case for FVH6 based on the YTD data. Using the net basis in regression seems problematic since it depends on your carry calculation which depends crucially on the appropriate term repo rate. In fact, it might be more appropriate to regress change in net basis vs. change in 30y spreads. Implied repo might be better since you're backing out the market implied funding rate, and regressing that against actual repo rates (as the metric for secured funding balance sheet scarcity) seems fine.
Finally, I think GC is certainly not the best choice, because this goes back to balance sheet scarcity and hidden funding costs only partly reflected in the nominal secured funding rate. With 30y spreads, the problem for me at least is figuring out what's actually priced in. It seems to me overall poorer funding conditions due to balance sheet have been priced in to some extent. Front-end spreads are typically more responsive to the funding component. The question I guess is what's currently driving long-end spreads and does it continue to reflect balance sheet pressures.
Yeah, I normally don't look at BBG for the implied repo levels and the time series, especially intra-day.
I agree with you broadly. Don't think there's anything particularly exciting to do in front contracts, given the current pricing. Back contracts are, obviously, a lot juicier, but then the various costs are significantly higher.
With the front contracts you also have a last delivery date on 4/5/2016 through quarter-end, so it looks even less attractive for long basis if you price to 3/31/2016.
I edited my above comment above about the choice of GC vs. 30y spreads. Unfortunately it pretty much amounts to "I don't know what's really driving 30y spreads recently".
My theory, from my interactions with various mkt participants, is that it is just a matter of severe balance sheet pressures which apply across the board. And yes, in the past, balance sheet consumption used to be defined in terms of notional (or mkt value or whatever), which meant that the shorter dated the bond, the more it would consume. My guess is that the various new regulations imply that consumption is now also a function of duration. That's a big shock to the system and it's just one of several (another big one is the increasing cost of repo faced by the pension funds).
Thanks, mentioned the embedded optionality in a low-rate environment primarily for background context. I agree that the cheapening of the net basis is balance sheet driven, but can you expand on the relationship between vol and B/S scarcity? I guess you mean the vol this scarcity produces is not the healthy kind typically conducive to basis trading, and makes determining "fair value" difficult and perhaps irrelevant. And even if you can obtain cheap funding, overall funding conditions and access to B/S (which are correlated but distinct) are pretty bad, helping produce swings that can make the marginal cost of long basis position outweigh marginal benefit.
And I would imagine this applies more broadly to various types of cash-synthetic trades, e.g. swap spread collapse and negative cash-cds basis. So I guess if there's anything to do it's to try to evaluate rich/cheap of the futures and maybe trade that against another synthetic.
Yeah, so my point about volatility is simply to observe that the amount of funding tail risk (a la 2008, albeit for an entirely different set of reasons) that one faces nowadays has increased to the point where I, for one, would feel uncomfortable having large exposures. Moreover, the fears of the "tails" also increase your PNL volatility during normal times. So your stress risk-adjusted and vol-adjusted returns are just not sufficiently good, IMHO.
remember that in 2008, the bond future net basis hit -14 ticks because of the scarcity of balance sheet in a banking crisis. There are 2 major banking crisis issues facing the market right now: oil and china (and lets not forget europe). Oil firm bankruptcies will hit banks with NPL writeoffs. China bankruptcies because of high interest cost will cause 30% devaluation of the Yuan within the next year as the PBoC will be forced. to bailout/recap the chinese banks.
So, there are lots of things to worry about, and capital has become scarce. This causes net basis to trade negative until the turmoil is over.
Worth adding that CTDs vs surrounding bonds, and futures vs cash have traded rich for a while in most currencies given the large OI longs from CTAs. It is still mostly just a balance sheet trade, but can make a decent amount of money if for example (like in the UK) the front end prices in a high chance of a cut, then the implieds actually look very attractive and so give you more to play with.
Thanks, -14 ticks seems plausible. My guess is basically it looked like a cheap synthetic term repo, except the actual term Treasury GC markets weren't available. Overnight Treasury GC was functioning and richened around the Bear Stearns collapse, compensating those willing to lend out Treasuries against cash. The risk of not getting your high quality (and more valuable in a flight to quality trade) collateral back was perhaps justifiably high. Provided you had dry powder, just close out repo altogether (de-lever) and go long fixed-income.
I haven't looked at bond basis in other countries, but if the front-end prices chance of a cut wouldn't that be reflected in lower implied repo, after adjusting for balance sheet costs and funding risk?
all the US CTD basis markets are trading at a zero net basis right now...so there is no arb to be done. The net basis trades negative AFTER a crisis begins to unfold..which we have not seen yet. In 2008, the net basis didn't go negative until AFTER Lehman went bankrupt...
Not sure which feed you're looking at but live pricing from CME shows CTD net basis is currently trading negative in TUA, FVA, TYA, WNA. Futures have cheapened on relative basis vs. last week when thread made, so net basis was more negative then.
A funding crisis is likely a sufficient but certainly not necessary condition for the net basis to trade negative. Current negative net basis is due to concerns surrounding balance sheet costs and general availability. Back in 2005 net basis traded negative simply because there was large open interest relative to float of CTD, hence CTD was getting squeezed closer to delivery. Negative CTD net basis there reflected arb opportunity for long basis positions ONLY IF they could actually deliver into the contract. If not they incurred cost of roughly the difference in net bases between the first CTD and 2nd CTD, which is assumed here to be less than the cost of failing to deliver into the contract.
Yea, I see that it's negative pretty much across all contracts... The back contracts, FWIW, look significantly worse (or better, whichever way you wanna think about it).
If we quantify the discussion, at what basis would you find lets say WNM6 attractive? I think on Friday I saw gross basis of +15 ticks, i.e. net basis of -5 assuming 100 bps repo.
Not sure I understand all the risks other than basis going more negative. Cost of o/n borrowing staying above ~160bps for 3 months? The repo counterparty not returning your treasuries? Haircut getting too large?
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