Yield Curve Spread Trades:

Opportunities & Applications

ANDREW P. SHOOK, CEO & FOUNDER, CURVETRADES LLC
June 2013

ABSTRACT

Yield curve spread trades provide a wide variety of market participants the opportunity to generate returns and effectively
hedge portfolios. Yield curve spread trades are often de-correlated to the absolute direction of interest rates. We review yield
curve spread trade mechanics and execution using cash bonds and futures contracts.

INTRODUCTION

making yield curve spread trades intuitive

Yield Curve Spread Trades, a.k.a curve

and easy to understand will catalyze wide

Awareness of the yield curves impact

trades1, provide market participants

adoption. Yield curve spread trades enjoy

on equity markets, the economy and

return generating and hedging

predictable risk profiles and attractive

monetary policy is growing. Here we

opportunities. Curve trades occur in the

correlation characteristics relative to

included selected examples of the

most liquid interest rate markets including

other major asset classes. An additional

yield curve in recent news.

U.S. Treasuries, futures, other government

benefit to executing a yield curve spread

bonds, swaps and euro-dollars. Due to the

using CME Group futures is the margin

operational simplicity and deep market

offsets available for certain yield curve

liquidity, many market participants prefer

spread pairs.

to execute curve trades in the futures

Curve trades bring value and insight to:

markets.
Large institutions and professionals have
traded the yield curve spread for decades.
In our opinion, the lack of intuitive, easy to
use tools has hindered broader adoption
of yield curve spread trading. CurveTrades
believes that the yield curve spread sector
offers a largely untapped asset class with

Core Fixed Income Managers

Hedge Funds

The Yield Curve as a Leading Indicator,

The Federal Reserve Bank of New Yorks
dedicated web page to the yield curve.
Fed Expands Operation Twist by $267
Billion Through 2012, Bloomberg

Foreign Exchange

6/20/2012.

Equity Managers

Institutional investors are reaching

Risk Management

out for new risk management tools to

Asset / Liability Management

address shortcomings in estimating

risks that left them more exposed to

global opportunities.

Banks and Insurance Companies

losses in the financial market crisis than

Just as mutual funds enabled wide access

Pension Plan Managers

they expected. Pension & Investments,

to diversified equity portfolios and REITs

Research Analysts and Economists

brought easy access to commercial real

estate portfolios, we believe that tools

CTAs / Managed Futures

The CME Group refers to yield curve spread trades as Inter-Commodity Spreads.

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

5/13/2013

YIELD CURVE SPREAD TRADES DEFINED2:

A yield curve spread is the yield differential between two different maturities of a bond
issuer i.e. 10 yr U.S. Treasury yield 5 yr U.S. Treasury yield. The later maturity leg of the
trade is referred to as the back leg and the trade leg maturing earlier is called the front leg.
Two primary yield curve spread strategies are the flattener and the steepener.

Yield Curve Spread Flattener

The flattener makes money when the
yield differential decreases, or narrows.
Sell the spread to put on a flattener
(SHORT front leg vs LONG back leg).

YIELD CURVE
SPREAD STRATEGY

ACTION

FRONT LEG

BACK LEG

Flattener

SELL Spread

SHORT

LONG

Steepener

BUY Spread

LONG

SHORT

The risk measure for yield curve spread trades is DV01 (dollar value of a basis point). As
the back leg DV01 is greater than the front leg DV01, one must calculate a hedge ratio to
result in a DV01 neutral position. The CME Group offers a simplified execution via fixed
ratio yield curve spread trades using unique ticker symbols. A partial listing of the ticker

Yield Curve Spread Steepener

symbols follows:

The steepener makes money when the

SPREAD NAME

FRONT LEG

BACK LEG

CME FIXED RATIO

JUNE 2013

TUF

2 YR (ZT)

5 YR (ZF)

1:1

TUT

2 YR (ZT)

10 YR (ZN)

2:1

TUB

2 YR (ZT)

BOND (ZB)

4:1

TUL

2 YR (ZT)

ULTRA BOND

6:1

FYT

5 YR (ZF)

10 YR (ZN)

3:2

FOB

5 YR (ZF)

BOND (ZB)

3:1

FOL

5 YR (ZF)

ULTRA BOND (UB)

3:1

NOB

10 YR (ZN)

BOND (ZB)

2:1

NOL

10 YR (ZN)

ULTRA BOND (UB)

3:1

BOB

BOND (ZB)

ULTRA BOND (UB)

3:2

yield differential increases or widens. Buy

the spread to execute a steepener (LONG
front leg vs SHORT back leg).

Source: CME Group

The CME Groups paper Yield Curve Shifts Create Trading Opportunities is another excellent resource on the subject. Available by
going to: www.cmegroup.com/trading/interest-rates/yield-curve-shifts-create-trading-opportunities-strategy-paper.html
2

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

Not only do the CME Group fixed ratio

The following figure compares a $10

spreads simplify execution risk, they

million notional NOB spread execution

Net Change Market Quotation

Standard:

eliminate legging risk. While the simplicity

via a fixed ratio, DV01 neutral and a best

The CME Group quotes the yield curve

and legging risk mitigation is attractive,

of both worlds combo approach. The

spread market on a net change basis.

there are some potential pitfalls.

combo approach leverages the inherent

Although some consider it less than

advantages of the fixed ratio spread order

completely intuitive, there is solid logic

and adds a small order to one trade leg

stemming from the history of net change

to make the trade DV01 neutral, thus

market quotes for inter-commodity

eliminating the open DV01 risk. The small

spreads. By definition, an intercommodity

additional order should have minimal

spread is the spread between two different

execution risk.

commodities i.e. corn/soybeans or crude

Tail risk (open DV01 risk) depending on

trade size
Tail risk (open DV01 risk) can be
difficult to quickly quantify
Not all FCMs / trading platforms
support the CME Group yield curve

oil/gasoline. When applied to physical

spread tickers.

commodities, net change market quotes

are intuitive. But interest rate futures are
fundamentally different.

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

Three side effects stem from the net

CME GROUP YIELD CURVE SPREAD NET CHANGE MARKET QUOTE SCREEN

change quotation standard:

Spreads with very different yield
spreads i.e. 2s5s (TUF) @ 40 bps and
2s30s (TUL) @ 273 bps can be quoted
at the same price
Markets are often quoted as negative
numbers
There is no concept of the actual yield
differential.
An alternative approach would be to
present the market using the actual yield
differential of the cheapest to deliver
securities for each pair. CurveTrades
market presentation looks like this:
Source: CME Group

Yield Curve Spread Trade Performance

SPREADS QUOTED IN YIELD DIFFERENTIAL

Characteristics:
An attractive characteristic of yield curve
spread trades is that performance is
independent of absolute interest rate
changes. As the transactions are long /
short by definition, market rallies or selloffs do not generally affect performance
in the same way an outright long or short
bond or futures position would be affected.
And, to repeat, performance is not
tied to changes in absolute levels of
rates, but rather changes in the yield
differential between two rates. In a rising
rate environment where rates increase
from 1.75% to 5.00% and the yield
curve steepens, a long NOB position will
be profitable while your outright long
competition is down! This is a critically

Source: CurveTrades

important point please take a minute

and re-read this section.

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

Cash 2s10s Absolute SpreadTM

THE ABSOLUTE SPREADTM

The Absolute SpreadTM is a yield curve

comparison:

spread metric developed by CurveTrades.

While the cash 2s10s yield curve spread

Absolute Spread

flattened in nominal terms from 2010-

TM

measures the current

yield curve spread as a percentage of its

2012, the Absolute SpreadTM became

maximum possible value. The maximum

steeper. We believe this is significant.

is the yield of the back leg.

CurveTrades developed Absolute SpreadTM

Absolute SpreadTM =

to help traders, portfolio managers and

yield curve spread / back leg yield

others comprehensively analyze the yield

The Feds monetary policy and

curve and the yield curve spread.

quantitative easing programs have driven

YIELD CURVE SPREADS AND

yields on U.S. Treasury securities to

LARGE CAP EQUITY PERFORMANCE

historical lows.

CORRELATION:

U.S. Treasury

Low Yield
(Summer 2012)

5 yr

0.55%

10 yr

1.45%

30 yr

2.45%

The yield curve is generally thought to be

a leading indicator of equity performance.
The yield curve and its correlation to
equity markets is an often researched and
widely published topic. A Google search
of yield curve spread equity correlation
returns some 2.86 million results. The

These low yields artificially cap the

Federal Reserve Bank of New York, the

applicable yield curve spreads. For

FDIC and Duke Universitys Fuqua School

example, the 2s10s cash yield curve

of Business are among the first page

spread cannot be 250 bps when the

search results. The New York Fed has

10 yr cash treasury yields 1.45%. Its

a web page titled The Yield Curve as a

simply not possible!

Leading Indicator.

Date

Cash 2s10s

10 yr Treasury

Absolute SpreadTM

2/19/10

2.90%

3.68%

79%

2/7/11

2.90%

3.73%

78%

7/26/12

1.26%

1.45%

87%

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

The slope of the yield curve is heavily

THE CHARTS BELOW SHOWS THE YIELD CURVE SPREAD VERSUS LARGE CAP

influenced by central bank monetary

EQUITY RELATIONSHIP:

policy. The yield curve reflects current

The Yield Curve Spread as a Leading Indicator

monetary policy, expected monetary

2s10s Yield Curve Spread vs. S&P 500

policy actions and inflation expectations.

Central banks raise and lower rates to
reign in / stimulate the economy. A flat

2s10s Yield Curve

Spread

yield curve indicates tight monetary

policy. Steep yield curves reflect periods
of monetary stimulus. As a result the yield
Recent
Govt
stimulus is
affecting this
relationship

curve can be used as a leading indicator

for major equity indices and yield curve
spreads have low correlation to major
equity indices.
GENERATING RETURNS. ADDING

Flat/Inverted Yield Curve

S&P 500

ALPHA. MANAGING RISK.

Flat or inverted
yield curves tend
to signal equity
market highs

Yield curve spread returns are easy to

understand. Broadly speaking, the gross
return of a yield curve spread trade can
be described as:
basis point change in yield curve spread
*DV01

Source: CurveTrades LLC, Federal Reserve Bank of St. Louis FRED

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

Source: CurveTrades LLC, FRED/St.

Louis Fed

Before we dig into the details, lets have a look at estimating the return available on

How do we estimate returns? A simple

a hypothetical transaction. The chart below plots the NOB yield curve spread (CME

way to estimate returns is to the basis

Group: ZN vs ZB futures contracts). Importantly, the NOB yield curve spread in the

point change in yield curve spread and

chart below accurately reflects the economic cost basis in the cheapest-to-deliver

multiply the average DV01.

securities based on the futures price.

NOB Spread Change

Avg DV01 / Spread

44 bps
$165

Total Change / Spread

$7,260

Return on Notional

7.26%

This translates into a 7.26% unlevered

return. It is very important to keep in mind
that this example contemplates a long
time frame. As futures contracts mature
quarterly, one must roll into the new
contracts to maintain the trade. The roll
costs will affect the trades performance.
With increased risk, you could apply
maximum leverage on the position and
increase return on margin significantly in
this example.
We initiate a $10 million notional NOB flattening trade at 155 bps. Roughly a year later we
close the trade at 111 bps making 44 bps.
Hypothetical NOB Yield Curve Spread Flattener
(Notes over Bonds CME Group: ZN vs ZB)

Strategy:

Flattener

Action:

Sell NOB

Initiate

155 bps

Close

111 bps

Change

44 bps

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

TRADE EXECUTION

So we have looked at the NOB yield curve

spread over time, performed our analysis
and estimated potential returns. How
exactly do we execute the trade? There
are three alternatives:
1. execute an order for the front leg and
the back leg
2. execute a CME Group NOB spread
order
3. combination of both.
The figure to the right is from

Please note the return estimations do

Much of the difficulty stems from the

CurveTrades LLC and compares trade

not attempt to account for transaction

fact that U.S. Treasury securities are

execution alternatives.

fees, implied carry or any other costs. The

not exchange traded. Additionally, it is

example is purely hypothetical.

difficult to identify the cheapest-to-deliver

As you can see, you can Sell 242 ZN and

Buy 100 ZB or you can Sell 100 NOB.

Unfortunately, curve trades have

While the CME Group resets the spread

historically suffered from four problems:

ratios quarterly, the NOB ratio is generally

Operational complexity

2:1. Thus by selling 100 NOB spreads your

resulting position is:
NOB Spread (assuming 2:1 ratio)
Sell 100 NOB
ZN

(200)

ZB

100

Lack of yield based data availability

Confusing market quotation
methodology
An absence of widely available easy to
use analytical tools.

There is a 42 contract mismatch between

the DV01 neutral execution and the NOB
order. This mismatch is called the tail. As
seen above, an order placed to true up the
tail can be combined with the NOB spread
order to maintain a DV01 neutral position.

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

security and even more difficult to

determine the true implied cost basis in
the CTD for a given futures price.
Fortunately, advances in technology
have simplified the process. CurveTrades
LLC provides data and analytics for yield
curve spread trades using both cash and
futures instruments via an intuitive web
application.

DELIVERABLE SWAP FUTURES

NEW OPPORTUNITIES IN YIELD CURVE
SPREAD TRADES

In Q4 2012 the CME Group introduced

Deliverable Swap Futures (DSF). DSF
contracts are a futures contract on a forward
starting swap. These new contracts provide
similar economics to an interest rate swap
with the exchange traded clearing benefits
and margin efficiency of a futures contract.
Additionally, DSF create a new sector for
curve trades!
CASH VERSUS FUTURES EXECUTION:
PROS AND CONS

Execution of a yield curve trade can

be in either cash or futures markets.

APPLICATIONS: CORE FIXED INCOME

trade in U.S. Treasuries, particularly

MANAGER

10 years and shorter. This is a classic

Transparent pricing is difficult because

Managers of core fixed income portfolios

defensive response risk off and decrease

U.S. Treasury securities are not exchange

owned by mutual funds, pension and

duration. Now lets observe the impact to a

traded. Furthermore, the short leg of a

endowment funds, banks and insurance

bar-belled, credit biased portfolio. Equities

cash Treasury spread requires borrowing

companies face extraordinarily

sell-off, treasuries rally, rates decrease

the underlying bond and paying accrued

difficult challenges. The two main

and durations extend. So every basis

interest. The long leg requires buying

challenges are intense competition and

point the treasury market rally has more

accrued interest. These factors decrease

constantly changing portfolio duration.

DV01 horsepower than the last. One could

capital efficiency. One then needs to roll

Compounding this challenge is the

expect credit spreads to widen on a 1:1 or

both trade legs to stay in the on-the-run

historically low rate environment. Fixed

greater than 1:1 basis. So, via the cruelty of

security. The result consumes capital and

income portfolio managers may construct

the markets, the carefully and thoughtfully

imposes operational burdens.

bar-belled portfolios and increase

constructed core fixed income portfolio

allocation to spread product in search

could manage to turn in NEGATIVE

of yield. By definition, this dramatically

performance as U.S. Treasuries rally.

increases risk of under-performance via

In this scenario, your boss becomes

increases yield curve spread risk in a risk

angry, investors redeem their money and

off, flight to quality scenario.

before you know it, youre shining shoes

contracts do have a few idiosyncrasies;

The current modified duration of the

for a living. Not a good day at the office.

fortunately, tools are available that simplify

Barclays U.S. Aggregate Index is 5.37

But there is hope

the more complex aspects of executing

years . Credit spreads and equities are

You can execute curve trades to help

a futures based yield curve spread trade.

highly correlated. Should the Dow Jones

restore portfolio performance. There

These resources enable the market to

Industrial Average and S&P 500 Index

are many different strategies portfolio

easily identify value, structure efficient

markets crack from the current historical

managers can deploy.

trades and manage risk.

highs one could expect a flight to quality

Futures are exchange traded and capital

efficient. The CME Group and other
exchanges explicitly recognize the reduced
risk profile of a spread, and offer margin
offsets for certain curve trades. Futures

Barclays, 5/13/2013

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

One example is to overlay the indexs

curve attribution. Another strategy would
be to execute yield curve spread trades
that tracked an increased allocation to
spread product along various points of the
curve. A third approach would be to take
a more macro view. For example, one may
have the view that in the aforementioned
scenario, FYT will flatten and NOB and/or
NOL will steepen.
The core analytical tool offered by
CurveTrades allows you to investigate
the movement of futures and cash based
yield curve spread pairs over time. The
analytics also allow you to estimate
performance impact of yield curve spread
changes on a DV01 basis. Analyzing and

implied pricing for DSF vs U.S. Treasury

constructing yield curve spread trades is

futures in 5, 10 and 30 year maturities on

now easy and intuitive!

a 1:1 basis.

APPLICATION: CARRY TRADES AND

5-Year Treasury Futures (ZF) vs 5-Year

DELIVERABLE SWAP FUTURES IMPLIED

CREDIT SPREADS

Carry trades are executed via buying cash

Deliverable Swap Futures (F1U)

10-Year Treasury Futures (ZN) vs
10-Year Deliverable Swap Futures (N1U)

treasuries and shorting the like futures

contract i.e. long on-the-run 10 yrs and
short ZN. These trades can be executed
on a 1:1 par notional or on a DV01 neutral
basis. An effective way to easily estimate
available carry is to weight the yields
of the long and short legs. While this
approach is highly simplified from the
full on analysis, it generally paints a very
useable picture of the available carry.
Another application is the implied swap
spread using the CME Groups Deliverable
Swap Futures (DSF) contract versus its
U.S. Treasury future counterpart. In May
2013, the CME Group began offering

10

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

Ultra Treasury Bond Futures (UB) vs

30-Year Deliverable Swap Futures (B1U)
The implied credit spread can be
observed by comparing the DSF vs.
Treasury futures spread. One can trade
relative value between the implied credit
spread and the OTC market. This is a
powerful relative value insight!

DV01
Neutral

1:1 Ratio

10 yr DSF vs
ZN Spread

58 bps

92 bps

Cash 10 yr vs
ZN Spread

40 bps

76 bps

Implied Credit
Spread

18 bps

16 bps

Cash Treasuries and the DSF contracts

have very similar maturity profiles. The
Treasury futures contracts must grapple
the cheapest-to-deliver / deliverable
securities basket issue. For the 10 year
U.S. Treasury future, the CTD is currently
a 6.5 year 7.0 year maturity and the

LOOKING FORWARDFUTURE MARKET

according to a 2012 Greenwich Associates

DEVELOPMENTS

survey6. Retail FOREX market share

The retail marketplace represents the

vast untapped opportunity for curve

outstrips hedge funds, corporates and

insurance companies.

trades. In a strikingly similar parallel to

History will repeat itself. Product

the foreign exchange market of 15 years

development efforts and technological

ago, CurveTrades believes retail adoption

advances will bring retail access to yield

of yield curve spread trading will grow

curve spread trading that, until now,

to become a significant portion of total

was only available to large institutional

trading volume. Consider the facts: curve

investors.

trades represent the last highly liquid,

CONCLUSION

established asset class in which the

retail investor and wealth management
community isnt actively involved.

Yield curve spread trades offer a world

of opportunity that is easy to understand
and simple to execute. Core fixed income

Ultra Bond future is tending towards a

The U.S. fixed income market has ~ $38.5

managers, research analysts, hedge

25 year maturity. So the total DSF vs.

trillion par outstanding and enjoys daily

funds, economists and many others

Treasury spread is composed of a curve

average trading volume of over $800

benefit from participating in and actively

component and a credit component.

billion4. In addition to this cash volume,

following the curve trades market. When

By comparing the cash/ U.S. Treasury

average daily volume in CME Group U.S.

thought of as a core asset class with

futures spread to the DSF/U.S. Treasury

Treasury futures contracts was greater

global applications, market participants

futures spread we can identify the

than 2,800,000 contracts, representing

can diversify portfolios while increasing

curve component and imply the credit

~$280 billion notional5.

capital efficiency.

component by taking the difference. This

FOREX shared the exact same

creates exciting trading opportunities! If

fundamentals in the past: a global, highly

your view is the implied credit spread is

liquid market with solid infrastructure.

too tight, sell the DSF / Treasury spread. If

Retail participation in the FOREX market

it looks wide, buy it!

currently accounts for ~20% market share

4
5
6

SIFMA, Q1 2013
CME Group, Q1 2013 Quarterly Interest Rate Review
Greenwich Associates survey cited in Retail FOREX Trading Surges, WSJ 4/26/2012

For more information on CurveTrades, visit www.curvetrades.com

or email [email protected]

11

YIELD CURVE SPREAD TRADES: OPPORTUNITIES & APPLICATIONS

This information is not to be construed as an offer to sell or a solicitation or an offer to buy the securities, securities derivative or futures products named herein. Nothing in this report
shall be construed as any kind, or any type of trading or investment advice, recommendation or strategy, that is made, given or in any manner endorsed by CurveTrades LLC or the author.
The factual information of this report has been obtained from sources believed to be reliable, but is not necessarily all-inclusive and is not guaranteed as to the accuracy, and is not to be
construed as representation by CurveTrades LLC or the author. The risk of trading futures and options can be substantial. Past performance, whether actual or indicated by historical tests of
strategies, is no guarantee of future performance or success. There is a possibility that you may sustain a loss equal to or greater than your entire investment regardless of which asset class
you trade (options, futures or others); therefore, you should not invest or risk money that you cannot afford to lose. Futures and options trading is not suitable for all investors. Each investor
must consider whether any investment is suitable.
Copyright 2013 CME Group. All rights reserved.