Neil Sun, Portfolio Manager on the BlueBay US Fixed Income team, discusses “under the radar” risks which encircle the US Treasury market.
Watch time: 3 minutes, 24 seconds
View transcript
Welcome to the weekly fix. My name is Neil Sun.
In this week’s episode, we are going to discuss the Treasury basis trade – one of the biggest, riskiest trades hiding in plain sight.
First, what is a Basis Trade?
The basis trade involves buying a US Treasury bond and simultaneously shorting a Treasury futures contract. The goal is to profit from the small pricing differential or the “basis” between the cash bond and the futures.
To do this, investors such as hedge funds use repo markets to finance the bond purchase with cheap leverage. As a simplified example, an investor would buy Treasury bonds and use them as collateral to borrow money to buy even more Treasury bonds. When executed at scale, this becomes a highly leveraged arbitrage, picking pennies in front of a steamroller.
Why is this basis trade risky in 2025?
The trade exploded in size over the past years. Some estimates put hedge fund exposure over $600bn. The problem is - it relies heavily on repo liquidity and stable pricing between bonds and futures. But when volatility spikes – as we saw in early 2020 or even Q1 this year – those spreads widen, margin calls hit, and funds are forced to unwind.
The Fed and regulators have taken notice. There’s growing concern about systemic risks, especially because this leverage sits outside traditional bank regulation.
What could go wrong?
Imagine a scenario where Treasury volatility jumps, repo rates spike, or futures markets go illiquid. Forced unwinds could cause Treasury prices to tumble – even in the absence of real economic stress. That’s really the paradox – systemic shock from a low-volatility asset due to hidden leverage.
It’s not just theoretical. Back in March 2020 during the peak COVID vol shock we saw this trade unwind violently, freezing the Treasury market until the Fed stepped in.
What to watch from here?
There are couple things we should watch from here – any widening of cash-futures spreads, rising repo rates, and changes in margin rules from clearinghouses. Under volatile market conditions clearinghouses could increase margin and call for more money to be pledged, and this could potentially add to the funding pressure for investors. Also, stay tuned to regulators as this trade is now one of the top concerns in market risk discussions and stability reports.
When the world piles into a crowded trade built on leverage, the exit doors can get very small, very fast.
Hope this is helpful for everyone to understand or to refresh on the dynamic of the Treasury basis trade. Thank you again for watching.
Key points
The basis trade involves buying a US Treasury bond and simultaneously shorting a Treasury futures contract.
The goal is to execute the trade at scale to profit from the small pricing differential between the cash bond and the futures.
There’s growing concern about systemic risks - basically a shock from a low-volatility asset due to hidden leverage.
When the world piles into a crowded trade built on leverage, the exit doors can get very small, very fast.