Board of Governors of the Federal Reserve System

May 10, 2024

Why Do Mutual Funds Invest in Treasury Futures?

Benjamin Iorio, Dan Li, and Lubomir Petrasek¹

Asset managers' net long positions in Treasury futures have reached their historical highs in recent months, driven in part by mutual funds' demand for short- and medium-term Treasury futures. Analyzing mutual fund portfolio holdings reports on SEC Form N-PORT, we find that the increase in mutual funds' futures holdings since 2020 can be attributed to both increased demand for Treasury exposures during a higher interest rate environment and mutual funds' preference for sourcing these exposures through futures rather than securities. Treasury futures are much more widely used by mutual funds as a source of leverage than repo borrowing. To understand what explains some mutual funds' preference for futures, we examine the characteristics of mutual funds using Treasury futures and compare them with those of funds that invest predominantly in Treasury securities. In the cross-section of funds, we find that mutual funds' usage of Treasury futures is associated with greater risk taking, suggesting that mutual funds use the embedded leverage in futures to increase exposures to riskier assets. Finally, funds that use futures also tend to have higher cash holdings, more volatile investor flows and higher expense ratios.

Figure 1. Asset Managers' Net Position in Treasury Futures

What explains the time-series of assets managers' Treasury futures positions?

Figure 1 shows asset managers' net positions in Treasury futures based on the CFTC Traders in Financial Futures Reports. The notional value of asset managers' net long position in futures contracts tied to Treasury notes has recently reached record high levels, driven by increases in 2-, 5-, and 10-year note long futures positions.

In part, the elevated long futures exposures appear to reflect asset managers' demand for interest rate exposure amid a higher interest rate environment. Figure 2 compares asset manager long futures exposures with the underlying bond yields for the 2- and 5-year tenor. In the time-series, changes in asset managers' long futures exposures in shorter tenor Treasury futures are positively correlated with the changes in the corresponding Treasury yields. This finding suggests that the recent increase in asset manager's demand for shorter tenor Treasury futures is in part related to the higher interest rate environment, with futures being used to increase exposures to shorter-term interest rates. In contrast, the correlations between the changes in positions and Treasury yields are small and negative for longer tenors (not shown), suggesting that demand for longer tenor interest rate futures is not primarily driven by higher interest rates.

Figure 2. Asset Manager Long Futures Exposures vs. Underlying Yields by Tenor

Which types of asset managers hold Treasury futures?

Using quarterly holdings disclosures by mutual funds on SEC Form N-PORT, we estimate that mutual funds hold roughly $500 Billion in Treasury Futures as of 2023 Q4. The residual of the CFTC Traders in Financial Futures positions is held by other asset managers such as pension funds, insurance companies, endowments, and separate accounts, which hold roughly $650 billion in Treasury futures notional exposure. Since 2020 Q4, mutual fund exposures have grown by $220 billion and non-mutual fund exposures have grown by $330 billion. As shown in Figure 3, mutual funds account for the majority of the increase in the 2 and 5-year benchmark tenors, while other asset managers account for almost all the increase in 10-year and longer tenors. Our analysis of the N-PORT data speaks only to the increase in mutual funds' exposures, although the increase in non-mutual fund exposures has also been large.

Figure 3. Mutual Funds' Share of Asset Manager Treasury Futures Exposure

Increased demand for Treasury exposures or preference for futures?

The recent rise in mutual funds' futures holdings reflects both their increased demand for Treasury exposures and an increased preference for sourcing these exposures through futures. Mutual funds' long Treasury futures exposures have overall grown at roughly the same pace as those to cash Treasury securities since Q4 2020. In addition, as shown in Figure 4, left panel, the increase in mutual funds' Treasury exposures over the period – including Treasury securities and futures exposures – has been broadly in line with the increase in the outstanding Treasury securities net of SOMA holdings. Additional analysis (not shown) reveals that most of the increase is due to funds reallocating more of their assets toward Treasuries, both through futures and Treasury securities. Only a small part of the increase can be explained by flows into fixed-income oriented mutual funds.

Figure 4. Mutual Fund Treasury Exposure and Futures Share

In addition to the increase in mutual funds' overall demand for Treasury exposures, the share of those exposures sourced through futures has also increased over the past two years. As shown in Figure 4, right panel, futures' share of Treasury exposures has increased from roughly 30 percent in mid-2022 to 43 percent as of 2023 Q4. This increase explains roughly a half of the rise in mutual funds' Treasury exposures since mid-2022.

What explains mutual funds' preference for Treasury futures?

Why do mutual funds prefer futures over Treasury securities? One possibility is that mutual funds seek out the leverage embedded in Treasury futures contracts. Treasury futures have embedded leverage because the amount of Treasury market exposure is greater than the amount of capital required to set up and maintain a futures position. In theory, mutual fund managers have other means to access leveraged Treasury exposure, including through outright borrowing in Treasury repo. A Treasury securities position financed in repo can offer the same exposure and leverage as Treasury futures, without the associated basis risk.² In practice, the use of futures is much more prevalent among mutual funds than the use of Treasury repo. Among the mutual funds in our sample that report either Treasury futures or Treasury repo on SEC Form NPORT, 84 percent use only futures, 12 percent of funds use both futures and repo, and only 4 percent rely exclusively on repo to obtain leveraged exposure to Treasuries.

There are likely several reasons why most mutual funds prefer futures to repo borrowing. First, mutual funds have traditionally faced regulatory limitations on the size of their repo borrowing. Even though recent regulatory changes allow mutual funds to opt for equivalent treatment of repo borrowing and derivatives exposures, many funds are barred from significant borrowing by their investment mandates.³ In addition, if mutual funds borrow in repo, the associated interest expense may increase their reported expense ratios, which is another factor favoring the use of futures, particularly during high interest rate environments.⁴ The implied leverage in Treasury futures allows mutual funds to leverage their capital without borrowing. This feature of futures may be particularly attractive to active mutual funds seeking to enhance their returns or reach for yield by increasing their allocations in the non-Treasury part of their portfolios.

Mutual funds can use futures either to hedge or manage interest rate risk. Futures may be preferred for interest rate risk management because of their greater liquidity relative to cash Treasury securities, and their trading on centralized exchanges.⁵ Some mutual funds, such as those with volatile investor flows that require frequent adjustments to interest rate exposures may prefer to allocate a greater share of their Treasury exposures in futures since adjustments to futures exposures tend to be easier to implement and less costly.

To examine these hypotheses, we analyze next the characteristics of funds that invest predominantly in Treasury futures ("Majority Futures") and compare them with those of funds that predominantly hold Treasury securities ("Majority Bonds"). As shown in Table 1, funds that obtain most of their Treasury exposures through futures invest in more non-Treasury debt and take on more credit spread risk exposure, as measured by CS01. In contrast, there is no difference in portfolio interest rate exposures (DV01) between futures users and other funds. This is consistent with mutual funds' reaching for yield as it indicates futures users' propensity to buy riskier credit to achieve higher yields in the corporate bond market. Treasury futures facilitate such behavior by allowing mutual fund managers to increase their allocations to credit and other riskier assets while using futures to keep the portfolio duration aligned with their benchmarks. Table 1 also shows that futures users have a greater share of their portfolios allocated to cash, as would be expected if funds segregate cash for variation margin payments. However, the cash allocations are on average significantly lower than futures notional exposures, again indicating that the embedded leverage in futures is used by mutual funds to increase portfolio risk exposure. As further shown in Table 1, futures users have higher flow volatility on average, suggesting that these funds benefit more from the relative liquidity of futures in managing investor redemptions. Finally, futures users tend to have higher expense ratios than funds that are predominantly invested in Treasury securities, consistent with these funds investing in riskier assets and being more active.

Table 1: Characteristics of Cash and Futures Users

Mutual funds can use futures either to hedge or amplify interest rate risk. To understand how futures contribute to the portfolio interest rate risk, we examine the time-series and cross-sectional patterns of duration adjusted Treasury exposures. The left panel of Figure 5 shows the duration exposures, measured as the dollar value per one basis point decrease in interest rates (DV01), that are sourced through Treasury securities and futures. The DV01 sourced through Treasury futures is much smaller than the notional value of these exposures, largely reflecting mutual funds' preference for shorter Treasury futures tenors and, to a smaller degree, offsetting short positions. Overall, futures contribute just 7 percent of the overall portfolio DV01, while Treasury securities contribute 31 percent. As shown in the right panel of Figure 5, Treasury futures exposures appear larger if measured on a net notional basis – allowing for an offsetting between long and short futures exposures without regard to duration.

Figure 5. Mutual Funds' Net DV01 and Notional Exposure

We find that the changes in the Treasury security DV01 are uncorrelated with the changes in the DV01 of Treasury futures in the time series, indicating that Treasury futures are neither amplifying nor offsetting the time-series variations in Treasury security exposures. This near-zero correlation suggests that increases in Treasury futures use are not primarily driven by hedging or mutual funds substituting futures for Treasury cash exposures. Similarly, we also find at the fund level that the correlation between Treasury cash and futures DV01 is about as likely to be negative as it is to be positive. This finding confirms that mutual funds have various uses for Treasury futures, including duration extension and hedging.

Overall, this comparative analysis shows that futures usage in mutual funds is associated with greater risk taking, greater flow volatility, and higher expense ratios. These findings suggest that although mutual funds have various uses for Treasury futures, many funds use the embedded leverage in futures to increase portfolio risk and reach for yield. An important limitation of our analysis is that it is based on a simple comparison between groups of mutual funds according to their futures usage. More work is needed to establish causal relationships.