For a very long times rates on government bonds have been low. In particular they have been low with respect to the “notional rates” used in computing the conversion factors in bond futures.
Those rates were traditionally at 6.00% and are still at that level for US Treasury futures and most of German bonds futures. For the German bonds, the exception is the ultra long bond futures which are based on a 4.00% notional coupon. On the UK Gilt side, most of the notional rates are at 4.00% with the exception of the Short Gilt Futures based on a 3.00% notional coupon.
The recent market movements have brought the UK Gilt rates around 4.00%. Does this matter? What is the impact of the “notional rates” on the behaviour of bond futures?
Bond futures are settled by the physical delivery of a bond. The deliverable bonds are government bonds with a specific maturity range (plus some other conditions on size). The amount paid at delivery for the bond is the futures price multiplied by a “conversion factor” (and the notional). This conversion factor is computed (as a clean price) from the actual bond and from the notional rate. The impact of all this is that the notional rate act as some kind of strike. If the yield is below the notional rate, the shorter maturity bond is usually the cheapest-to-deliver; if the yield is above that rate, the longer maturity bonds is usually cheapest-to-deliver.
They are subtilties around that long/short maturity, in particular dependent on the coupons, as the EUR market has reminded us recently (see Bund volatility sparks uncertainty around futures delivery).
The delivery option that had been forgotten for a long time is now back in the discussion. A good opportunity to referenced to a more than 15 years old paper by Marc: Bond Futures and Their Options: More than the Cheapest-to-Deliver; Margining and Quality Option (2006).
Obviously, the techniques to analyze this issue have evolved over the last 15 years, and we have implemented several of them. Those proprietary developments are currently not available publicly, but are available to our advisory clients.
Don't hesitate to contact us if you are interested by modelling embedded options in vanilla products.