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description, tags
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| Yield curve spread strategies (flatteners and steepeners) trade the difference in yields between two maturities of the same issuer, going short the spread when rates are expected to rise and long when rates are expected to fall. |
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Yield Curve Spread (Flatteners & Steepeners)
Section: 5.13 | Asset Class: Fixed Income | Type: Yield Curve / Spread
Overview
Yield curve spread strategies trade the yield spread between two bonds of the same issuer at different maturities. If interest rates are expected to rise, the yield curve is expected to flatten (short end rises more than long end); if rates are expected to fall, the curve steepens. The strategy goes short the spread (flattener) or long the spread (steepener) accordingly.
Construction / Mechanics
Yield curve spread: the difference in yields between a longer-maturity bond (back leg) and a shorter-maturity bond (front leg) of the same issuer:
Spread = Y(back leg, long maturity) - Y(front leg, short maturity)
Trading rule:
Rule = { Flattener: Short spread if interest rates expected to rise
{ Steepener: Buy spread if interest rates expected to fall (416)
Position construction:
- Short the spread (flattener): sell shorter-maturity bonds (front leg) + buy longer-maturity bonds (back leg).
- Buy the spread (steepener): buy shorter-maturity bonds (front leg) + sell longer-maturity bonds (back leg).
Dollar-duration matching: to immunize against small parallel shifts, match the dollar durations of the front and back legs:
P_front · D_front = P_back · D_back
Without duration matching, a parallel shift in the yield curve can generate significant losses.
Payoff / Return Profile
- Flattener profits when the curve flattens: short-end yields rise more than long-end yields (or long-end falls more than short-end).
- Steepener profits when the curve steepens: long-end yields rise more than short-end (or short-end falls more than long-end).
- Dollar-duration-neutral construction limits losses from parallel yield curve moves.
Key Parameters / Signals
- Yield curve slope: R(long maturity) - R(short maturity) — the key signal
- Front leg maturity T_1, back leg maturity T_2: define the segment being traded
- Modified durations D_1, D_2: used for dollar-duration matching
- Interest rate outlook: the primary driver of direction (flattener vs. steepener)
Variations
- Curve trades across issuers: trading the slope difference between two issuers (adds credit spread risk).
- Butterfly trades: extend the two-leg spread to a three-leg position to trade curvature rather than slope (see Sections 5.6–5.8).
Notes
- Parallel yield curve shifts can cause losses if dollar durations are not matched; duration-matching is essential for a pure slope bet.
- Even with duration matching, large parallel moves (exceeding the immunization approximation) can generate losses due to convexity differences between legs.
- The strategy is exposed to idiosyncratic supply-and-demand effects at specific maturities (e.g., Treasury auction effects, central bank purchases).
- Financing costs (repo rates for the short leg) affect the net P&L of the strategy.