Yield Curve Trades: Steepeners, Flatteners and Butterflies

Yield curve trades are positions designed to profit from changes in the shape of the yield curve, such as the gap between 2 year and 10 year yields, rather than from the overall level of interest rates. Macro funds, bank trading desks and bond managers use them to express views on monetary policy, inflation and growth. Because the legs offset each other's sensitivity to parallel moves, these trades isolate the slope or curvature of the curve. See Yield Curves for the basics.

The main curve trades#

Weighting by DV01#

Each leg is sized so that its DV01 (dollar sensitivity per basis point) matches the other leg, removing exposure to parallel shifts. See DV01.

Instruments used#

• Cash Treasuries financed in repo.
• Treasury futures: for example, the NOB spread (10 year notes versus 30 year bonds) or futures spreads weighted by DV01. See Futures Spreads Explained.
• Interest rate swaps at different maturities. See Interest Rate Swaps.
• SOFR futures for the short end.
• Swaptions for option based curve views.

Butterflies#

A butterfly trades the middle of the curve against the two ends, for example the 5 year against the 2 year and 10 year.

• Long the belly (short the wings): profits if the 5 year yield falls relative to the average of the 2 year and 10 year.
• Short the belly (long the wings): the reverse.

Weights are chosen so the trade is neutral to both parallel shifts and slope changes, isolating curvature. Butterflies are also used for relative value when one maturity looks cheap or rich versus its neighbours.

Carry and roll down#

Curve trades earn or pay carry while held:

• Carry: the yield earned on long positions minus the financing cost and yield paid on shorts.
• Roll down: in an upward sloping curve, a bond's yield falls as it ages toward shorter maturities, raising its price if the curve is unchanged.

A steepener in an upward sloping curve often has negative carry and roll, so the curve must steepen enough to cover these costs. Traders always calculate "breakeven" moves before entering.

What drives curve moves#

See The Federal Reserve and the FOMC and Quantitative Easing and Tightening.

Risks#

• Wrong timing: curves can stay inverted or steep for long periods.
• Imperfect hedges: DV01 weights change as yields move.
• Financing costs for leveraged cash positions.
• Policy surprises and liquidity shocks.
• Leverage: curve trades often use large notional amounts, as in the case of Long Term Capital Management in 1998. See The Collapse of LTCM.

Frequently asked questions#

What is a yield curve steepener?#

A trade that profits if the gap between long term and short term yields widens, typically long short maturity bonds and short long maturity bonds, weighted by DV01.

What is a flattener?#

A trade that profits if the gap between long and short yields narrows, typically short short maturity bonds and long long maturity bonds.

Why are curve trades DV01 weighted?#

To remove exposure to parallel moves in yields, so the trade's profit depends only on changes in the curve's shape.

Next, learn the most used rate derivative in Interest Rate Swaps.