Morgan Stanley: Rates rise, fall or the curve reshapes: four options ideas from Morgan Stanley

Why choose a cross-maturity combination when rates rise moderately?

Morgan Stanley distinguishes between rates returning to near their recent highs and breaking above them. For the former, it recommends buying an at-the-money interest-rate upside option expiring in 2 years on the 10-year rate, while selling a similar option expiring in 3 months with a strike rate 50 basis points above the forward rate.
The implied volatility of the short-term option sold is about 10 basis points per year higher than that of the long-term option bought, and the premium received is about 9% of the cost of buying the long-term option alone. By the bank's calculation, over a 3-month observation period, the combination outperforms holding the long-term option alone if rates rise by no more than about 56 basis points.
The main risk is that rates fall while forward volatility declines, particularly when growth concerns trigger a flight to safety.

For a scenario in which rates break significantly above recent highs, Morgan Stanley favors buying a put option on USG7 Treasury futures with a strike of 103, and exiting its previously recommended USZ6 106 put option.
The bank believes that a sharp bond-market sell-off could cause the futures contract's cheapest-to-deliver bond to switch to a longer-duration bond, further increasing the futures contract's sensitivity to yield changes and generating additional convexity gains.
The option's loss is limited to the premium paid; its value could be impaired if long-end yields do not rise enough. Widening swap spreads could also offset some of the relative gains.

The bank recommends buying a 1-year interest-rate downside option on the 10-year rate, with a strike rate 50 basis points below the forward rate, while selling an upside option with a strike rate 58 basis points above the forward rate, using the same notional principal to establish exposure similar to holding duration.
Because the upside option's implied volatility is relatively high, the premium received from selling it can cover the purchase cost, resulting in zero initial net premium. But this also entails exposure to rising rates: at expiry, losses are unlimited once the rate exceeds the strike of the option sold.

When expecting the spread between 2-year and 30-year rates to widen, Morgan Stanley recommends buying a 6-month curve call spread, with strikes from the at-the-money forward level to 25 basis points above it. The initial cost is 10 basis points, the maximum payout at expiry is 25 basis points, and the loss is limited to the premium.
The bank notes that the volatility sensitivities of the bought and sold legs largely offset each other, so the combination is less affected by relatively high implied volatility. A backtest from January 2022 to April 2026, with a static curve hedge established at entry, showed an average loss of 1 basis points per trade; the trade faces losses if the curve continues to flatten.
When expecting the spread between 5-year and 30-year rates to narrow, the bank recommends buying a 6-month curve put spread, with an initial cost of 11.5 basis points and a maximum payout at expiry of 25 basis points. Over the same backtest window, the structure earned an average of about 0.6 basis points per trade; if the curve continues to steepen, the premium is at risk.