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Treasury basis and switch-option trades gain traction amid long-end selloff

Long-dated yields have climbed above 5%, with Bloomberg analysis suggesting the cheapest-to-deliver bond could shift if long-term yields rise another 10 to 30 basis points.

Reported · Written up by our desk · Government Bonds

A prolonged selloff in US Treasuries is opening relative-value opportunities for hedge funds and other arbitrage-focused traders, with Bloomberg highlighting pricing gaps between Treasury futures and the underlying bonds.

According to the report, long-end yields have climbed above 5% and the speed of the move raises the risk of disruption in the Treasury futures market, which can make the so-called Treasury basis trade more attractive. The strategy involves shorting Treasury futures while buying the cash bond identified as the cheapest to deliver, aiming to capture pricing differences between the two markets.

Bloomberg also points to a potential “switch option” component. When yields move sharply, the cheapest-to-deliver security can change, allowing traders who are short futures to switch into the newly designated cheapest-to-deliver bond and attempt to realize the resulting price differential.

The opportunity is gaining relevance as pressure builds at the long end, with a heavy corporate bond issuance calendar coinciding with a 20-year Treasury auction and a sale of long-dated inflation-protected securities. Bloomberg analysis cited by Hedgeweek suggests a 10 basis-point increase could move the cheapest-to-deliver reference from the August 2045 4.875% issue to the February 2046 2.5% bond, while a 30 basis-point rise could shift it further to the August 2049 2.25% bond. The strategy can still face risks, including transaction costs, timing of switches, and the need to adjust hedge ratios, which may add to volatility.

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