“It’s a no-brainer…”
As the yield on the 10Y US Treasury note broke above the 3.00% Maginot Line this week (for the first time since Jan 2014), traders piled on – pushing net speculative positioning for 10Y note futures to their largest short ever. In fact, along with almost $4 trillion notional in Eurodollar shorts (betting on rising short-term interest rates), the aggregate position across the rest of the Treasury futures space has also reached a new record short, which, as the chart below shows, is equivalent to well over 1.1 million 10Y futures contracts.
However, just as it became ‘obvious’ that rates were now set to rocket higher – umm growth and inflation and well stocks are awesome-er, right – yields tumbled…
And the yield curve flattened dramatically…
With both the level of the curve and its shape dropping notably on the week.
And while we are yet to see whether this record positioning will prove the crowd is always wrong again, there is one clear set of ‘losers’ already facing considerable losses – mom-and-pop investors in Wall Street’s latest and greatest ‘conservative’ bond offering – ‘Steepener’ Securities.
As Bloomberg reports, as the yield curve flattened to the lowest in more than a decade, the fallout spread beyond the realms of high finance and central banking. It also caused the value of hundreds of millions of dollars worth of debt — often held by retail investors — to evaporate.
Holders of ‘‘steepener’’ securities are facing the prospect of minuscule or even zero coupons. The structured products were issued in droves in recent years by Wall Street banks including Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley. Frequently marketed by brokers, they pay a high introductory fixed rate that switches to a floating coupon linked to the gap between short- and long-term U.S. interest rates.
The complex math behind the trade has been laid bare by the flattening curve, leaving a slew of retail investors blindsided, say critics, as issuance booms.
Globally, around $2.5 billion of notes tied to constant maturity swap rates was sold last quarter — the most since 2015 — scores of which use the steepener structure, according to data compiled by Bloomberg.
And as the price action of the following Goldman ‘steepener’ security shows, it has not been a pretty picture for mom-and-pop retail investors – lured by the promise of ‘low risk, bond like characteristics’ and higher than normal initial yields…
The products — to a large degree, a bullish bet on U.S. growth and inflation over the long haul — share the same basic structure. The steeper the slope, the higher the coupon, up to a cap.
If the curve levels out — as it has been over the past year — or inverts, buyers can be stuck with measly coupons or even no interest payments.
A $64 million steepener note issued by Goldman in 2013 is illustrative of how the flat curve has whittled down its value.
The security has recently slumped to 64 cents on the dollar as coupons shrank to less than 1 percent a year, according to TRACE data — a far cry from the 9.25 percent investors received at the beginning of the term, according to its prospectus. The coupon is calculated according to a formula based on the difference between the 30-year constant maturity swap rate and the five-year rate.
While banks issue the debt securities, Bloomberg notes that they’re often marketed and sold to investors via intermediaries such as brokerages. In some cases, the latter have been censured and fined by the Financial Industry Regulatory Authority for failing to ensure the products were suitable for their clients.
No banks were named in these actions.
“They were sold as being conservative investments, which of course they’re not,” said Jeffrey Pederson, an attorney in Denver, Colorado, who has represented investors in settlements against financial institutions over whether such notes were suitable for his clients.
Issuance has hardly slowed down this quarter, with around $1.9 billion of swap-linked notes sold globally through April 26. Many of these use the steepener structure, offering a high introductory coupon which then switches to a floating rate linked to the steepness of the yield curve.
“Your average person getting these things is Joe Salesman, and they end up losing a lot of money pretty quickly” if the curve flattens, said Pederson.
So once again – the sucker at the table was retail… and one wonders just how much of the record futures positioning is driven by mom-and-pop flows from ETFs as the ‘home-gamer’ is battered into submission day after day that ‘rising interest rates is a no brainer’… so why would you want to hold bonds, when stocks only go up in value?
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