In recent weeks, institutional investors have begun to question something previously unthinkable—the viability of the Treasury yield curve as a fixed-income benchmark. Treasury auction schedule changes, reductions in issuance and confusion over the announced Treasury buy-back plan have all caused unusual volatility in Treasury yields. The unsettled state of the Treasury markets has also led investors to seek high-grade alternatives to Treasury investments, such as Fannie Mae Benchmark Notes and Freddie Mac Reference Notes.

To take advantage of that uncertainty, three U.S. futures exchanges have introduced a series of new futures and options contracts on agency debt. On March 10, the Cantor Exchange launched five- and 10-year agency note futures. Four days later, the Chicago Mercantile Exchange launched contracts on the same maturities. And a day after that, the Chicago Board of Trade launched its own 10-year agency note futures and options. The new contracts, however, have met with varying degrees of success.

Different strokes

Agencies such as Fannie Mae and Freddie Mac were established to supply liquidity and provide stability to the U.S. home mortgage markets. While they receive no government funding, their charters give them the right to issue debt on a regular auction schedule to fund their mortgage lending activities. However, the new agency futures contracts shouldn't be confused with earlier attempts to launch futures on mortgage-backed securities. As derivatives on the Fannie Mae Benchmark Note and Freddie Mac Reference Note programs, these contracts are based on the non-callable, bullet-coupon debt of these two agencies and closely resemble each other, with one major exception—the conversion factor systems.

All trade in $100,000 increments and on the same quarterly cycle as CBOT Treasury futures. While slight differences exist in terms of which underlying notes are eligible for delivery, all the futures contracts call for physical delivery, and the CME and CBOT contracts trade in both open-outcry and electronic forums.

CBOT vs CME 10-YEAR AGENCY FUTURES CONTRACTS
Daily Open Interest Comparison
March 14, 2000 to Present

While the Merc and Cantor adopted 6.5 percent conversion factors, however, the CBOT uses the same 6 percent system in effect for its Treasury futures contracts. Because the agency contracts of all three exchanges allow for the delivery of issues with a variety of coupons and maturities, as do CBOT Treasury futures, market users need a means of calibrating the prices of the various deliverable issues with each other and with the price of the futures contract.

Conversion factors serve that purpose. Essentially, a conversion factor is the price of $1 par to yield the stated amount from the last day of the delivery month to maturity. The futures price times the conversion factor will approximate the price of the underlying issue. Conversely, the cash price divided by its conversion factor will approximate the futures price.

Trading history

The CME's 10-year agency note futures contract enjoyed far stronger volume at the outset. But after the second week of trading, the CBOT contract was both the volume and open-interest leader. Moreover, during April's 19 trading days, the CBOT 10-year volume totaled 92,476, an average of 4,867 contracts daily, while the CME's volume for April totaled 4,276. During the same month, CBOT open interest grew from 19,699 contracts to a peak of 29,000, while CME open interest began April at 5,101 and dropped to 3,704.

The CME's 10-year agency note futures contract enjoyed far stronger volume at the outset. But after the second week of trading, the CBOT contract was both the volume and open-interest leader.

These differences in volume and open interest growth follow in large part from the growing importance, to risk managers and traders, of the TAG (Treasuries over Agencies) spread. The TAG represents the credit spread between agencies and Treasuries. For example, with 10-year Treasury futures trading at 96–31 and 10-year agencies at 91–03, the 10-year TAG spread is 7–28. In early March, the 10-year TAG would have been more like 3–16. Like any credit spread, the TAG can move independently of yield levels—and credit spreads are frequently more volatile than interest rates. In general, the credit and interest-rate components of a corporate yield are separate and respond to different forces.

While Treasury futures have long provided a cost-effective and efficient means for managing interest rate risk, they don't correlate well with the credit component. The new agency futures do. In recent years, week-to-week changes in 10-year agency yields and the 10-year swap rate show a 0.975 correlation vs. a correlation of approximately 0.93 between 10-year Treasury yields and the 10-year swap rate. Clearly, based on this evidence, the TAG spread affords an effective means of managing credit spread risk inherent in high-grade corporate bonds and swaps.

The CBOT 10-year agency contracts appear to benefit from trading at the same exchange where 10-year Treasury futures trade and from having the same conversion factor as the Treasuries. Currently, CBOT sources report, slightly more than half the agency volume comes from TAG spreads.