Bond futures are financial derivatives that obligate the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond futures contract trades on a futures exchange market and is bought or sold through a brokerage firm that offers futures trading. The contract's terms (price and expiration date) are decided when the future is purchased or sold.

How Bond Futures Work

A futures contract is an agreement entered into by two parties. One party agrees to buy, and the other agrees to sell an underlying asset at a predetermined price on a specified date. On the futures contract's settlement date, the seller must deliver the asset to the buyer. A futures contract's underlying asset could be a commodity or a financial instrument, such as a bond. Bond futures are contractual agreements where the asset to be delivered is a government or Treasury bond.

A bond futures contract can be held until maturity, and it can also be closed out before the maturity date. If the party that established the position closes out before maturity, the closing trade will result in a profit or a loss from the position, depending on the value of the futures contract at the time.

Bond futures are standardized by the futures exchanges and are considered among the most liquid financial products. A liquid market means that there are plenty of buyers and sellers, allowing for the free flow of trades without delays. As such, the bond futures contract is used for hedging, speculating, or arbitrage purposes:

• Hedging is an investing strategy that attempts to protect holdings.
• Arbitrage is a strategy that takes advantage of an imbalance in prices. Traders try to profit from purchasing an asset or security on one exchange or venue and sell it on another.
• Speculating is investing in products that have a high-risk, high-reward profile. A bond futures contract allows a trader to speculate on a bond's price movement and lock in a price for a set future period.

Bond Futures Delivery

As mentioned earlier, the seller of the bond futures can choose which bond to deliver to the buyer counterparty. The bonds that are typically delivered are called the cheapest to deliver (CTD) bonds, which are delivered on the last delivery date of the month. A CTD is the cheapest security that's allowed to satisfy the futures contract terms. The use of CTDs is common with trading Treasury bond futures since any Treasury bond can be used for delivery as long as it is within a specific maturity range with a specific coupon or interest rate.

Futures traders typically close positions well before the chances of delivery. In fact, many futures brokers require that their customers offset positions (or roll to later months) well before the futures expiration.

Bond Futures and Margin

Many futures contracts require margin, meaning a trader needs to deposit and maintain a specific amount in their brokerage account. This amount is generally much smaller than the notional value of the futures contract, and it must be deposited when a futures position is opened.

A broker requires an initial margin and a maintenance margin. Should the bond futures position decline sufficiently in value, the broker might issue a margin call, which is a demand for additional funds to be deposited.

Bond Futures Risks

The risk of trading bond futures is potentially unlimited for either the buyer or seller of the bond. Risks include the price of the underlying bond changing drastically between the exercise date and the initial agreement date. Also, the leverage used in margin trading can exacerbate the losses in bond futures trading.

Where to Buy Bond Futures

Bond futures trade primarily on the Chicago Board of Trade (CBOT), which is part of the Chicago Mercantile Exchange (CME) Group. Contracts typically expire quarterly: March, June, September, and December. Examples of underlying assets for bond futures include:

• 13-week Treasury bills (T-bills)
• 2-, 3-, 5-, and 10-year Treasury notes (T-notes)
• Classic and Ultra Treasury bonds (T-bonds)

Many brokers offer bond futures, such as Charles Schwab/TD Ameritrade, Interactive Brokers, and TradeStation.

Managing a Bond Futures Position

Each day, before expiration, the long (buy) and short (sell) positions in the traders' accounts are marked to market (MTM), or adjusted to current rates. When interest rates rise, bond prices decline—since existing fixed-rate bonds are less attractive in a rising-rate environment.

Conversely, if interest rates decrease, bond prices increase as investors rush to buy existing fixed-rate bonds with attractive rates.

For example, assume a U.S. Treasury bond futures contract is entered into on Day One. If interest rates increase on Day Two, the value of the T-bond will decrease. The margin account of the long futures holder will be debited to reflect the loss. At the same time, the account of the short trader will be credited the profits from the price move.

Conversely, if interest rates fall instead, bond prices will increase, the long trader's account will be marked to a profit, and the short account will be debited.

Bond Conversion Factors

The bonds that can be delivered are standardized through a system of conversion factors calculated according to the rules of the exchange. The conversion factor is used to equalize coupon and accrued interest differences of all delivery bonds. The accrued interest is the interest accumulated and yet to be paid.

If a contract specifies that a bond has a notional coupon of 6%, the conversion factor will be:

• Less than one for bonds with a coupon less than 6%
• Greater than one for bonds with a coupon higher than 6%

Before the trading of a contract happens, the exchange will announce the conversion factor for each bond. For example, a conversion factor of 0.8112 means that a bond is approximately valued at 81% of a 6% coupon security. The price of bond futures can be calculated on the expiry date as:

• Price = (bond futures price x conversion factor) + accrued interest

The product of the conversion factor and the futures price of the bond is the forward price available in the futures market.

The Bottom Line

Bond futures obligate the contract holder to either buy or sell a bond at a predetermined price on a specific date. Bond futures traders try to profit from price changes in the short term, and usually do not hold the contracts until expiry to avoid being forced to accept delivery. There are benefits and drawbacks to futures trading—the consistently fluctuating market can increase profits significantly, but it also puts traders at greater risk.