CTD Switching and Delivery Basket Risk

A Treasury futures contract's price behavior is really the behavior of one specific bond: whichever one in the deliverable basket is currently cheapest to deliver (CTD). That's convenient as long as the same bond stays cheapest. The problem is that "cheapest" is a moving target — as yields rise or fall, the relative value of bonds with different coupons and maturities shifts, because conversion factors are fixed at a 6% assumed yield while actual market yields are not. When the CTD identity flips from one bond to another, the futures contract's duration and yield sensitivity can change abruptly, even though nothing about the contract itself was traded.

Why switches happen

At yields near 6% (the conversion factor's assumed yield), conversion factors do a reasonably good job of equalizing bonds across the basket, so the CTD tends to be whichever bond has the lowest duration (shortest maturity, highest coupon) among eligible issues — low-duration bonds are relatively insensitive to the fact that yields aren't exactly 6%. As yields fall well below 6%, the highest-duration, lowest-coupon bond in the basket tends to become cheapest to deliver, because conversion factors systematically underweight how much extra a low-coupon, long-duration bond is worth once yields are low. As yields rise well above 6%, the opposite tends to happen. This creates a rule of thumb: rallies push the CTD toward longer-duration bonds, selloffs push it toward shorter-duration bonds — which, notably, amplifies the futures contract's price moves in a rally and dampens them in a selloff, a mild negative-convexity-like effect from the basket mechanics themselves.

Worked example

A 10-year Treasury futures basket has two candidate bonds: Bond X, a 4.5-year duration issue with a high coupon, and Bond Y, a 7-year duration issue with a low coupon. At current yields of 4.5%, Bond X is cheapest to deliver, and a fund hedging a corporate bond portfolio with these futures has calibrated its hedge ratio assuming the futures contract behaves like a 4.5-year duration instrument. Yields then rally sharply to 3.2% over two months on a growth scare. The CTD switches to Bond Y, and the futures contract's effective duration jumps from roughly 4.5 years to roughly 7 years overnight. The fund's hedge, sized for a 4.5-year-duration instrument, is now under-hedging its portfolio's rate exposure by a meaningful margin, purely because of the basket mechanics, without the fund having done anything wrong at the time the hedge was set.

Worked example: positioning ahead of a likely switch

A relative-value desk notices yields are drifting toward a level where models suggest the CTD is likely to switch within the next month. They can put on a small position betting on the switch itself: buying the bond expected to become the new CTD and selling the current CTD, DV01-weighted, anticipating that the futures price will begin tracking the new bond's behavior as the market prices in the expected switch even before it technically occurs, since futures prices reflect the probability-weighted expectation of which bond will be cheapest at delivery, not just today's snapshot.

What this means in practice

Anyone hedging with Treasury futures needs to monitor where current yields sit relative to the basket's switch thresholds, especially during periods of high rate volatility, because a CTD switch changes the hedge's effective duration without any explicit rebalancing trigger. Desks running futures-based basis trades also watch for switches because the trade's entire risk profile (which cash bond is implicitly being financed) changes at the switch point.