Explainer: Classic one-way levered Treasury bond trades

The US Treasury market is enormous and rich with trading opportunities for leveraged players in the market. Below we describe two of the most classic and common of the “one-way” levered trades.

Why “one-way”? Because these are trades that tend to only be put on in one direction because the thesis is that there is a chronic mispricing in the market and thus the trade is only profitable in one direction: long off-the-run cash treasuries. The opposite would be long-short equity, people are on both sides, or futures which by definition have a short for every long. This lack of balance between longs and shorts is the reason that when they need to be unwound they tend to disrupt the market.

Why “levered”? Because of the inherent low price volatility in treasuries there is not enough potential return in these trades unless they employ leverage to get the return potential to an acceptable level. This is why in the end these trades are basically bets on the availability of funding.

Who is a levered player? Hedge funds, banks, anyone that requires repo financing of long cash positions. These are market participants that when that funding becomes unavailable must unwind their positions into the market as they cannot sustain the positions without repo funding.

The trades are:

Long off-the-run (OFTR) versus short on-the-run (OTR) treasuries
The theory is that OFTR Treasuries trade at a higher yield than the most recently issued on-the-run (OTR) because the OTR command a liquidity premium and trade at a lower yield than they should otherwise. So levered players buy the OFTR and short the OTR. If they are right then they will earn the slightly higher yield from the long OFTR position than the interest paid on the short of the OTR.

Long OFTR vs Futures
Futures contracts on US Treasuries trade at a premium (higher price, lower implied yield) because they do not require balance sheet to hold the positions, while cash treasuries do. This trade would earn a profit if it is possible to fund the long position of cash treasuries to the delivery into the futures contract at a lower rate than implied in the futures price.

What really are these trades? They are bets on the availability of funding from lenders. If the trader can secure financing of their long positions during the lifetime of the trade then everything will work out profitably. But if repo financing becomes unavailable they must sell as they do not have enough cash to fund the positions internally. Historically when repo financing becomes unavailable it is a system wide fact, not for a single market participant. So when one leveraged player in the market is forced to unwind they all are at the same time. This is what causes the spasms in the market we have seen historically.

Why people care?

• Because Volker explicitly exempted Treasuries from the ban on proprietary trading, regulated and implicitly guaranteed banks are free to employ these trading strategies.
• Because the Treasury market is the way the country finances its debt and expenditures, any disruption in the operation of the market has far reaching consequences on the nation as a whole.