When it comes to bond futures contracts, there is a fairly obscure little secret that savvy traders know about. This secret allows those who are aware of it to cash in on the difference between what they need to pay for their bond and what they receive upon delivery. It's called "cheapest-to-deliver" and here we'll show you how it works and how you can use it in your bonds futures trading.
What is the cheapest-to-deliver bond
The term CTD or cheapest-to-deliver refers to the contract with the lowest margin requirement when you are delivering bonds in order to cover a futures position. The CTD bond is related to your futures position because when you go short on bonds, you need to deliver them when the contract expires.
If you sell 10 contracts of bond X at $100 and then deliver them when the contract expires, you will want to deliver the bond with the lowest margin requirement. In this case, that would be a lower-priced bond from the same issuer, so you might deliver bonds worth $90 each.
In practice, you don't have to worry about determining which specific bonds are cheapest-to-deliver because nowadays bond futures exchanges do this for you.
How does cheapest-to-deliver work
The CTD calculation is determined by the futures exchange, not by you. One factor that influences the calculation of cheapest-to-deliver is interest rates, specifically their recent movement. The current 30-day average rate on a bond will factor into its CTD status.
When the price of one bond goes up relative to other bonds in the same issuer's series, its CTD status will go down because it might not be cheaper to deliver than other bonds in the issuer's series. If this happens, that bond may be automatically switched out for a different one when you deliver your position.
The exchange automatically gives you the option of receiving the next CTD bond and takes care of this calculation and transaction for you, so you won't need to worry about this.
Benefits of cheapest-to-deliver bonds
The main benefit of CTD positions is that the bond you receive has the lowest possible margin requirement when you deliver it to close your futures position. This can save you a lot of money, so smart traders know how to take advantage of it by buying or shorting bonds with this in mind.
There are other benefits to using cheapest-to-deliver positions, including:
- A lower yield
CTD positions will generally have a lower yield than other bonds because the issuer has already hedged its position in the bond futures market and is willing to sell at a lower margin (or deliver it with a higher margin).
- Less volatility
CTD positions tend to be less volatile because they are hedged. The exchange takes all the risk out of the position for you, so while CTD positions may have a lower yield, their prices tend to hover around par -- unlike other non-CTD issues which fluctuate wildly with market conditions.
- More security
CTD positions are considered more secure by investors because they are hedged. In the event that a company goes bankrupt, CTD positions will be paid off at par value at maturity, unlike other non-CTD issues which could be worth less than what you bought them for.
Keep in mind that cheapest-to-deliver is only one factor to keep in mind when making your investment decisions.
Conclusion
Investing in cheapest-to-deliver bond futures can help you improve your returns and cut costs, but it's no panacea. As with any investment strategy, trading CTD might work for some traders and not others. So make sure to conduct extensive research before you begin trading.
Originally Published Here: Cheapest-to-Deliver Bond
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