Trading the Yield Curve

March 14, 2011

Investors are giving up on bonds. In the last couple of weeks, bond prices have soared and yields came falling down.

So how can investors take advantage of the bond markets? New investment products are popping up that help investors bet on the spread between short-term and long-term rates.

The new derivatives are based on the yield curve. The options specifically focus on the difference between the 2- and 10-year Treasury yields. This month, that spread has widened to a record high of three percentage points. Historically, the average spread has been 0.84 percentage points, according to Morningstar Inc.

Since last week, the curve flattened a little as news was coming in from Libya, but nevertheless, the curve is quite steep by historical standards. Last week, the 2-year Treasury and the 10-year Treasure were yielding 0.74% and 3.42%, respectively.

What does the signal mean?
Traditionally speaking, when the yield curve gets steeper, it is usually a sign of the beginning of an economic expansion. Investors expecting growth to increase pace, sell off long-term bonds. The sell off drags bond prices down and their yields up. The yield curve is very sensitive to interest rates, so when the Federal Reserve cuts short-term rates, the yield curve steepens. However, when investors rush back to bonds for worries of an upcoming economic downturn, this pushes bond prices up and yields down and, as a result, the yield curve flattens.

Investors can bet on the flattening or steepening of the yield curve by purchasing exchange-traded notes. The iPath U.S. Treasury Steepener ETN (STPP), for instance is up over 10% since the Federal Reserve announced another round of bond buying back in the fourth quarter of 2010. The ETN's objective is to profit from a steepening yield curve. In contrast, the iPath U.S. Treasury Flattener ETN (FLAT) is designed to capture returns when the yield curve flattens. Over the same period that the STPP ETN was up the FLAT ETN was down. Over the past several months, money has been flowing into the expectations that the Fed will soon increase short-term rates to battle increasing inflation.

The risks involved
Some of these ETNs are new investment products and as such trading is sparse, which can result in wide bid-ask spreads - which is the prices buyers are willing to purchase shares vs. the prices sellers are asking for shares. A wider bid-ask spread, includes heftier transaction costs with it, which can deteriorate an investor's total returns potential every time they buy or sell shares. Also, because of the way ETNs are structured, primarily as unsecured debt securities issued by financial companies, investors can lose their entire investment if the issuer of these securities goes bankrupt.

Nevertheless, it is a good trading idea to hedge against short-term fixed income risks. Since the spread is at record highs, it is likely that the yield curve will flatten.

Hard to predict
Knowing where interest rates will go is difficult. If rates move higher, investors will take a hit on their existing bond prices, because newer bond issues will make older, lower-yielding bonds less attractive to investors. However, if the Fed will move to raise short-term rates in the near future, the yield curve could flatten.

It's generally a good idea to maintain bonds under 10 year maturities, if at all. For investors willing to stomach a bit more risk, consider adding a year extra to your maturity - for instance, from a 5 year corporate bond to a 6 year corporate bond. This may typically bring in an extra 0.3% to 0.4%. Historically, you would get only 0.10 percentage point increase by adding an extra year.

Bond investing can be complex. Consider speaking with your Isakov Planning Group Financial Advisor to carefully evaluate whether or not these strategies are appropriate for you and your portfolio.