The NOB, or note over bond spread, gives traders and investors a means with which to play anticipated changes in the yield curve. The yield curve is simply the difference between short-term and long-term interest rates. For example, the difference in yield on the five year note versus the 30 year bond.
The NOB spread is designed to take advantage of changes in the yield curve rather than trying to profit from fluctuations in the outright treasury futures contracts. In other words, a trader is only concerned with changes in the curve and is not concerned about whether bonds or notes are simply rising or falling.
How to Construct a NOB Spread
A NOB spread is actually quite simple to initiate. The Chicago Mercantile Exchange, or CME, publishes a spread ratio that determines how many contracts should be used. A spread ratio of 3:1, for example, means the NOB will be comprised of 3 three ten-year note futures contracts to a single bond futures contract.
Whether you buy the ten-year notes and sell the bond or vice versa depends on your market forecast. The yield curve can either steepen or flatten.
A steepening yield curve means that long-term rates will be rising more than short-term rates. A flattening yield curve means that short-term rates will be rising faster than long-term rates. In other words, the yield curve can either expand or contract.
If you believe the yield curve will flatten, you would sell the ten year notes and buy the bond. Remember that interest rates move inversely of price.
If you believe the yield curve will steepen, you would buy the ten year notes and sell the bond.
The determined spread ratio will remove the market “noise” from minor fluctuations and will move based on changes in the curve.
NOB spreads can be initiated by legging into the spread or by using the exchange traded spread. Exchange traded spreads may offer some potential advantages such as tighter bid/ask spreads while removing the “legging” risk.
The NOB spread can be useful for both speculation and hedging purposes. While there is the possibility of profit, there is also the possibility of loss. Futures trading carries significant risks and is not suitable for all investors. Past performance is not necessarily indicative of future results.
