What it means
The yield curve is a line that plots the yield on government bonds of different maturities, from a few months to thirty years. Normally the curve slopes upward, because lenders want more compensation for locking up money for longer.
A steepening means that the gap between long-term and short-term yields is increasing. A steepener trade tries to profit from this change.
The trader buys the shorter-dated bond, which gains when its yield falls, and sells the longer-dated bond, which gains when its yield rises. The two legs are sized so that the position has little exposure to parallel shifts of the curve and instead depends on the difference between the two yields.
The sizing usually relies on DV01, which stands for the dollar value of one basis point. It is the amount a bond's price changes when its yield moves by 0.01%.
If the short leg and long leg have equal DV01, a small parallel move in yields has no net effect, and the trade makes money only if the spread, meaning the difference between the two yields, changes. There are two common ways in which a steepening occurs.
In a bull steepener, short-term yields fall faster than long-term yields, which often happens when a central bank cuts rates. In a bear steepener, long-term yields rise faster than short-term yields, which can occur when investors worry about inflation or government borrowing.
Steepener trades are used by hedge funds, banks and asset managers. Some use them to express a view on economic policy, while others use them to hedge a portfolio that would lose money if the curve steepened.
The risk is that the curve flattens instead, and the position loses. Costs and financing also matter.
The trader must fund the long position and receives funds from the short position, and the difference in yields between the two bonds affects the daily carry. A steepener can therefore lose a little each day even when the curve is not moving, and the trader needs a view on timing as well as direction.
In practice
Real-world examples.
Example
A hedge fund expects the central bank to cut short-term interest rates while inflation worries keep long-term yields high. It buys 2-year government bonds and sells 10-year bonds in equal DV01 amounts. When the cuts arrive, the curve steepens and the fund earns a profit.
Example
A life insurer holds long-dated bonds and is concerned about rising long-term yields. It adds a steepener position as a partial hedge. If long yields rise, losses on the bond portfolio are offset by gains on the short leg of the steepener.
Example
A portfolio manager at an asset manager explains to her investment committee why a fund holds a steepener. She shows a simple table with the expected gain if the curve steepens by 20 basis points, the loss if it flattens by 20, and the daily cost of carrying the position. The committee approves the trade with a firm loss limit.
Formula
Calculation
Profit and loss = DV01 of the short-dated leg x fall in its yield (in basis points) + DV01 of the long-dated leg x rise in its yield (in basis points).
Suppose a trader buys 2-year bonds and sells 10-year bonds, each leg with a DV01 of $5,000 per basis point. Over the next month, the 2-year yield falls by 5 basis points and the 10-year yield rises by 15 basis points. The 2-year leg gains 5 x 5,000 = $25,000, and the short 10-year leg gains 15 x 5,000 = $75,000. The total profit is 25,000 + 75,000 = $100,000, which equals the 20 basis point steepening multiplied by $5,000.Case study
Seen in the real world.
This fictional story is illustrative only. Meridian Asset Management is an invented investment firm that manages a bond fund of $500,000,000.
The portfolio manager believes that the economy is slowing and that the central bank will cut rates within a year. She opens a steepener by buying 2-year bonds and selling 10-year bonds, each with a DV01 of $20,000. The firm's risk team sets a stop-loss of $1,000,000 on the position.
Over three months the spread between the two yields widens by 30 basis points, producing a profit of 30 x 20,000 = $600,000. The manager closes half of the position to lock in the gain and keeps the rest. The risk team records that the trade performed as planned and that its worst loss during the period was $250,000.
Watch out
Common mistakes.
- Treating the trade as a bet on the direction of interest rates. It is a bet on the difference between two rates.
- Ignoring carry and financing costs. The position can lose money each day even if the curve does not move.
- Using equal amounts of each bond. The legs should be matched by DV01, because longer bonds are more sensitive to yield changes.
Questions
People also ask.
What is the opposite of a steepener?
A flattener, which profits if the gap between long-term and short-term yields narrows.
What is a basis point?
It is one hundredth of one percentage point, or 0.01%.
Can a steepener lose money?
Yes, if the curve flattens or if the cost of holding the position exceeds the gain.
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