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By Timothy Strauts

The U.S. Treasury yield curve is the fundamental measure of the current state of the fixed-income markets; it shows the current interest rate available in Treasury bonds over a range of maturities. The curve starts at one-month maturity and goes all the way out to 30 years. It is created by plotting the yield at the various maturities on a graph and connecting the points to form a line. The natural shape of the yield curve is upward sloping, indicating that investors are paid higher interest rates for investing their capital for longer periods of time.

The slope of the yield curve is used to divine the market's expectations for the future direction of the economy and interest rates. The standard measure of the slope of the yield curve is the difference between 10-year and two-year interest rates. Because longer-dated bonds generally have higher yields than shorter maturities, this yield spread is usually positive. Since 1976, the average yield difference between 10-year and two-year bonds is 0.83%. A yield spread of more than 1.5% would be considered a steep yield curve, and a spread of less than 0.5% would be considered flat.

A flattening yield curve is one where the difference between long-term rates and short-term rates is decreasing. During economic recoveries, the yield curve typically flattens as the Federal Reserve raises short-term rates. Conversely, a steepening yield curve is one where the difference between long-term and short-term rates is increasing. Yield curves often steepen during economic downturns as the Federal Reserve cuts short-term interest rates and rates at the long end of the curve remain unchanged. The curve can also steepen in response to higher inflation expectations in the future.

The current yield spread as of Nov. 8 is 2.19%. Historically, this is a very high spread and can be explained by the Federal Reserve's decision to maintain short-term rates near 0%. Over the past 34 years, the yield spread has been this high only 9.7% of the time. Like many things in the world of finance, the yield curve tends to revert over time to its long-term average.

An investor looking to make a bet on the future direction of the yield curve could do it through Treasury futures contracts. This would be expensive and complicated to implement on your own, so these trades have been left to institutional investors. Barclays recently launched two exchange-traded notes that seek to give investors access to these strategies in a cost-effective way. The iPath US Treasury Flattener ETN (NASDAQ:FLAT) seeks to capture returns from a flattening yield curve. The iPath US Treasury Steepener ETN (NASDAQ:STPP) seeks to capture returns from a steepening yield curve. Both ETNs charge a fee of 0.75%, which is reasonable considering the strategy employed. The securities are structured as ETNs, which means that you need to consider the credit quality of Barclays in your decision. Barclays Bank currently has a credit rating of AA- from Standard and Poor's and AA3 from Moody's. For more information on how ETNs work, check out our ETF Solutions Center.

Because you can't directly invest in the yield curve, these ETNs track the Barclays US Treasury 2Y/10Y Yield Curve Index. The index holds about 75% of assets in long positions in two-year Treasury futures and 25% in short positions in 10-year Treasury futures. The index is rebalanced monthly to maintain a fixed level of sensitivity to changes in relative yields. The index should rise if the yield curve steepens and fall if the yield curve flattens. It seeks to increase by 1 point for each 1 basis point (0.01%) increase in the yield curve. STPP was initially priced at $50.00 per share and will increase by $0.10 for every 1-point rise in the index. FLAT was also initially priced at $50.00 per share and will decrease by $0.10 for every 1-point rise in the index. For example, if the difference between two-year and 10-year rates goes from the current 2.19% to 1.19%, then FLAT should rise about $10.00 per share. Based on a current net asset value of $52.82, this would equate to about an 18% gain.

In practice, the returns of FLAT and STPP will not match perfectly with changes in the yield curve. These ETNs were launched on Aug. 9, 2010, so we have a few months of data to see how they have tracked. At launch, the yield curve was at a 2.36% spread between two- and 10-year rates. As of Nov. 8, the yield-curve spread decreased by 0.17%, and, as expected, FLAT's net asset value increased 5.64% and STPP's net asset value decreased by 6.08%. Both ETNs performed about as anticipated.

The current very steep yield-curve spread of 2.19% potentially makes FLAT an attractive position in the current environment. There are two scenarios where we could see the yield curve flatten over the next several months. In the first, the United States could enter a period of deflation. In that environment, yields across the curve should continue to drop. The two-year Treasury is at only 0.41%, and the 10-year Treasury is at 2.60%. If rates drop, the 10-year yield would likely fall further than the two-year, which would flatten the curve because the two-year has less distance to fall because of its lower limit of 0%. In the second scenario, the U.S. economy could steadily recover and the Federal Reserve would likely raise short-term interest rates. When short-term rates rise, they usually rise faster than long-term rates, which would flatten the yield curve.

An investment in FLAT could offer an attractive return but should be thought of as a trade that needs to be watched. The trading volume on FLAT is currently quite small, so any trades should be done with limit orders. With all the uncertainty in the direction of future interest rates, FLAT is a desirable complement to a fixed-income portfolio.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Two ETNs to Take Advantage of a Steep Yield Curve