fixed income - How to trade interest rate futures calendar spread?

This has always been difficult to understand for me. How is the second futures contract valued in relation to the front month contract? My understanding is there are carry considerations (3 more months of carry for basis) and there is basis switch price involved. However, in a world of prolonged low volatility and low nominal rate levels, basis switch is a thing of the past. So is carry be the main driver for calendar spread? Then assuming the same CTD, a long calendar spread position would be short front month basis and long next futures' basis.

Answer

Trading bond futures calendar spread is actually a very involved exercise, with many moving parts. But first things first, recall that bond futures price is approximately: $$ F = \text{spot price} - \text{carry} - \text{delivery option value (DOV)} \pm \text{rich/cheap}.$$ So calendar spreads represent the differences in spot prices, in carries, in delivery options, and in the relative richness/cheapness.

This decomposition gives some clues on what drives calendar spreads:

1. Duration: Typically (not always), the back-month contract has longer duration. When yields rise, the back contract will lose more money than the front contract, causing calendar spread to widen (rise). This suggests that bond calendar spread is actually very directional with interest rate. (Of course, you can always hedge out the duration risk by trading DV01-weighted calendar spread.)


2. Curve: When the yield curve steepens, back contract is also likely to underperform the front contract, which causes calendar spread to widen as well.


3. Repo: This affects the carry component. Back contract has more repo exposures. When repo rate rises, back contract increases in value more than the front, causing the calendar spread to tighten. This factor becomes important when the Fed is active.


4. Switch Option: Assuming delivery option is involved, then back contract is likely to be more sensitive to rising volatility. As a result, higher implied volatilities will widen calendar spread. A detailed scenario analysis should also be performed to determine how CTD switches may affect contract valuation.


5. Relative Value: Futures may trade rich or cheap relative to fair value in persistent patterns, perhaps because market participants behave in predictable ways that cause temporary imbalances (more on this next).



6. Flows: During the roll period, perhaps the most important factor is flows. Real money asset managers tend not to hold their bond futures into the delivery month (because they can't accept physical delivery) and have to roll over to the next contract pretty much around the same time. So how they are positioned will affect the valuation of calendar spread profoundly. For example, if they're predominantly long, then they'll, in aggregate, have to sell the front contract and buy the back contract, causing calendar spread to tighten (all else equal).