by Brandon Clay
There’s been a lot of talk recently about a flattening yield curve, a condition where the yields on short-term and long-dated Treasuries converge. This is especially bad news for banks because a major source of profits for money-center banks is the ability to borrow money at short-term rates and lend at long-term rates. When the yield curve is steep – that is, when long-term rates are much higher than short-term rates – banks can make some tidy profits. When the yield curve flattens, the banking business can turn ugly.
One could argue that a flat yield curve will force banks to make more and riskier loans. In addition, consumers and business owners will want to borrow more because the terms are more favorable. But this doesn’t seem to be happening. Consumer credit continues to shrink in the weak economy. A bank’s ability to boost profits is in serious peril, which is probably bad news for the broader market. In other words, a flat yield curve has the potential to chase investors from equities into bonds.
While the yield curve may sound like a wonkish concept reserved only for professional bond traders, retail investors can now profit from flattening and steepening in the curve, too. This is possible thanks to the introduction of two new exchange traded notes: STPP and FLAT.
Right now fears of a lingering recession seem to be further flattening the yield curve, so we’ll focus on the iPath US Treasury Flattener ETN (NYSEARCA:FLAT). FLAT tracks the Barclays Capital US Treasury 2Y/10Y Yield Curve Index. This index measures the spread between two-year and 10-year Treasury yields. The ETN is designed so that a 0.1% change in the spread between those two yields should result in a 2% price move for FLAT. Essentially, that means FLAT is a leveraged play on the yield curve. Investors will need to exercise the same caution they would with traditional leveraged ETFs.
Investors should also fully understand the composition of the index that FLAT tracks. The index is 76% weighted to a long position in futures contracts on two-year Treasury yields and 24% weighted to a short position in 10-year Treasury yields. Beyond that, the expenses involved with FLAT are higher than most fixed-income ETFs and ETNs. FLAT has an annual expense ratio of 0.75% and also dings investors with a one-cent hit to NAV when it rolls the contracts it tracks.
If you want to play the flattening yield curve, consider buying FLAT. Given that this instrument recently came to market, you may just want to keep an eye on it for now. Be sure you use a limit order if you do decide to purchase the ETN. FLAT may do well while the yield curve is flattening, but it is equally important to realize that losses are certain if the yield curve steepens. To exploit a flattening yield curve in a touchy investment environment, go with FLAT.
Data from the Federal Reserve H.15 Report, click to enlarge
Disclosure covering writer, editor, publisher, and affiliates: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.