Long-term U.S. Treasury yields surged past 5%! A historic sell-off of $31 trillion in Treasury bonds has triggered a trading frenzy in "conversion options" due to the basis arbitrage window.

Notably, the U.S. Treasury market, which has reached a scale of $31 trillion, has experienced a sustained sell-off, opening the door to potentially lucrative trades that profit from pricing changes between derivatives and their underlying spot bonds. Long-term U.S. Treasury yields have surged above 5%, reaching a nearly two-decade high, and the duration at this level marks the longest since 2007. Although the dramatic fluctuations in yields may disturb the U.S. Treasury futures market at the Chicago Mercantile Exchange (CME), they have also created an arbitrage windowtraders can short CME's futures contracts while simultaneously purchasing the Cheapest to Deliver (CTD) spot bonds. Participants engaged in such basis trades can profit from the so-called "conversion options," as sudden changes in yields may switch the cheapest delivery security to a more inexpensive bond. Traders holding short positions can identify these securities from a compliance delivery basket and convert to the next bond that has recently seen a price decline, thus earning the profit from the price differential between the two CTD bonds. Long-term U.S. Treasury yields are elevated As U.S. Treasuries (especially the long end of the yield curve) come under renewed pressure, this strategy may gain popularity. This week, a busy corporate bond issuance schedule coincided with a 20-year Treasury auction and the release of long-term inflation-protected securities (TIPS), pushing the 30-year U.S. Treasury yield to a 19-year high on Monday. In this context, the underlying securities' conversion could happen quickly. Data analysis shows that for every 10 basis point increase in long-term yields, the Cheapest to Deliver security may switch from the currently cheapest 4.875% bond maturing in August 2045 to a 2.5% bond maturing in February 2046. If a more significant sell-off occurs, leading yields to rise by 30 basis points from current levels, the CTD security will switch to a 2.25% bond maturing in August 2049. Barclays Bank's interest rate strategists have highlighted the emerging option value in the current high-yield environment. Strategists Andres Mokk and Amrut Nahikar wrote in a recent report, "When long-term yields exceed 5.0%, there is a conversion risk for U.S. Treasury contracts." They added that "a massive sell-off" could lead the CTD in the delivery pool to extend to further out maturities, while a rebound would shorten its duration. The timing and transaction costs involved in utilizing the Cheapest to Deliver bond conversion options could erode the profits from basis arbitrage trades. The conversion between delivery bonds may also force futures traders to recalculate how many futures contracts they need to short or go long for hedging and adjust their buying or selling accordingly, which could further disturb the market. Although such arbitrage trades are relatively limited, the current backdrop of rising oil prices and an unclear path for Federal Reserve policies provides traders (especially those tracking the longest-duration U.S. Treasuries) with more opportunities.