How to Play the Yield Curve Through ETNs

by: Lawrence Weinman

In addition to the ETNs that focus on particular parts of the yield curve which I reviewed in my previous article, iPath has introduced instruments that allow investors to take positions on the shape of the yield curve. Specifically, these instruments allow one to take a view on the spread between 2 year and 10 year Treasuries. Institutional investors and traders have long taken positions on this relationship through futures and swaps but these instruments offer the simplest and most direct means for smaller investors to do so. The two iPath ETNs are ticker symbol STPP which increases value when the yield curve steepens (the differential between 10yr and 2 year rates increases) while the ETN with the ticker FLAT increases in value when the curve flattens.

Put simply, these instruments allow investors to take a position on the relationship between short and long term interest rates rather than an outright view on the level of interest rates for a particular maturity. The iPath website gives a basic introduction to the factors with regard to economic activity, the business cycle and monetary policy that might lead to changes in the shape of the yield curve. The instruments can serve both hedgers and those taking an outright view on the shape of the curve.

These vehicles could prove particularly interesting given current market conditions. The current yield curve is very steep with the difference between 2 year and 10 year Treasuries currently at 2.87%. This is a consequence of the Fed’s low interest rate policy since the recession which has kept the short end of the yield curve at near zero levels. Despite QE2, the Federal Reserve has less direct ability to influence the longer end of the yield curve. Since October, an increase in inflationary expectations as well as concern for the size of the US deficits has led to a selloff in longer term bonds (increase in yields) and a sharp steepening of the yield curve (see chart, click to enlarge) from 2.10% to 2.87%. (The graphs also include real yields = TIP yields.)

US Treasury Yield Curve Oct 2010 vs Feb 2011Click to enlarge

As a point of reference pre-financial crisis, in the summer of 2008, 10/2 year spreads stood at 1%.(below). Another very interesting point on this graph is the sharp increase in real rates (TIP yields) in the 5 year maturity (click to enlarge).

US Treasury Yield Curve Sep 2,2008 vs Feb 17.2011Click to enlarge

The graph below (click to enlarge) gives a long term view of the 10 year/2 year interest rate spread showing that the differential is at historically high levels. Not surprisingly, the periods with steep yield curves (large differentials between 10 year and 2 year yields) were usually preceeded by recessionary periods and Fed policy which cut rates to stimulate economic activity. As the economy recovered in past periods, the Fed ended its easy money policy and the yield curve “reverted to the mean” with the differential narrowing.

10 Year Treasury Yield – 2 Year Treasury Yield:

10 Year Treasury Yield - 2 Year Treasury YieldClick to enlarge

Based on current market conditions, investors or traders might well be looking to position themselves for a reversion to the mean in the yield curve regardless of their view on the future level of interest rates overall. The yield curve could flatten with both short term and long term rates going up. For that reason initiating an interest rates futures position or simply going short a short term Treasury ETF (SHY, SHV,TUZ) or even the combination of a short position in a short term Treasury ETFand a long position in a long term interest Treasury ETF instrument (TLO,TLT,TLH,IEF,TENZ) might not produce a return that matched the change in the yield curve.

In fact, looking at the extreme shape of the current yield relative to historic levels as well as the historically low levels of long term interest rates it would seem a reversion to the mean might well come through an increase in both short and long term interest rates as well as a flattening of the yield curve. Only through the yield curve trade can the investor/trader create a position where he takes a pure play on the yield curve.

Hedging Application

An investor with a bond ladder portfolio or any other portfolio with bonds spread out across several maturities might find the yield curve ETNs an attractive vehicle. It would be difficult and expensive for the investor to alter his overall bond portfolio in light of current market conditions. Yet looking at the shape of the yield curve he can see that a yield curve flattening could hurt his portfolio in a number of scenarios:

  • If the curve flattens with short term rates rising while long term rates remain unchanged he will suffer capital losses on his short term bonds but no offsetting gains on the longer term part of his portfolio.
  • If the curve flattens with short term interest rates rising more than long term rates, but long term rates increasing at the same time –a steepening and upward shift in the curve the investor is left with losses on all parts of his bond portfolio.

Taking a long position in the STPP ETN would allow his portfolio to profit from a flattening of the yield curve even if it occurs with the overall level of rates increasing. He would also not entail the costs and complications involved in selling individual bonds.

Trading the Yield Curve

Looking at the economic outlook, monetary policy and the yield curve, those looking to take an outright view on the yield curve might reach the conclusion that either the appropriate position is a long position in either the STPP or FLAT.

FLATeners- reversion to the mean: Many market participants would look at the graphs above and argue that the steepness of the yield curve is “overdone” the curve is too steep and will flatten. The economy is beginning to recover, there are threats of inflation, and the Federal Reserve will soon turn to tightening and short term rates will rise from their near zero levels. The result will be a flatter yield curve even if all rates across the curve move higher. I would put myself in this camp but must point out that many have been making the argument for a flatter yield curve for quite a while and have seen it steepen instead.

The attractiveness of the yield curve ETNs as opposed to futures trades or other positions involving margin or swaps, is that they can be established without margin or leverage. Thus the trader positioning for a “reversion to the mean” can hold onto the position without cash flow issues even if it initially moves against him. Unlike the leveraged investor he may not “run out of money” before the market reverts to the mean.

Steepeners who would hold a long position in the STPP would likely hold a more pessimistic economic outlook. They would see some combination of incipient inflation, no progress on the budget deficits, and slow near term economic growth. In such a scenario investors (“bond vigilantes”) would demand higher rates on long term bonds while the Fed would continue to keep short term rates low.

Others might expect the Fed to wind up “behind the curve” in raising short rates in response to inflationary forces while the end of the Fed’s quantitative easing would reduce demand for longer term maturities. The consequence would be a further steepening of the yield curve which could continue even after short term rates began moving up. Clearly this group has been right since the beginning of the financial crisis in 2008.

In all of the above scenarios the FLAT and STPP ETNs give smaller investors a direct way to position for changes in the yield curve in ways previously only available to institutional investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.