Yellen’s Six-Month Timeline to Raise Rates Threatens Swap Notes

Structured notes tied to the gap between short- and long-term rates, some of the most popular this year, may lose value after Federal Reserve Chairman Janet Yellen said borrowing costs could rise early in 2015.

Shorter-term rates climbed at a faster pace than longer ones after Yellen said on March 19 that the benchmark funds rate could start increasing six months after the Fed ends its asset-purchasing program. U.S. investors hold $2.09 billion of “steepeners” issued since 2010, which are so-called because they yield more when the spread between two rates widens, according to data compiled by Bloomberg.

The securities, which have become more popular since the start of 2013, bet on a slow recovery where the cost of money for shorter periods remains substantially lower than for longer maturities. Yellen’s comments have sent short-term rates up faster than the gradual rise the market expected, Neela Gollapudi, a New York-based strategist at Citigroup Inc. (C), said in a telephone interview.

The two most popular kinds of steepener notes are tied to the spread between either the two- or five-year and the 30-year constant-maturity swap rates, Bloomberg data show. The swaps reflect the cost to periodically exchange a fixed-maturity rate with a floating rate for example.

The difference between the five- and 30-year swaps has narrowed to 174.8 basis points yesterday from 194.2 the day before Yellen’s comments on March 19. Sales of U.S. securities linked to the two rates soared by more than 16 times last year to $764.2 million.

Shrinking Spread

Over the same period, the spread for the two- and 30-year swaps declined to 297.3 basis from 310.3. Banks have issued $1.64 billion of notes tied to the gap between the rates since January 2010.

Goldman Sachs Group Inc. sold 15-year notes tied to constant-maturity swaps on March 6, 2013, that slid three cents in less than a week to 91 cents on the dollar on March 24, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The $64 million of securities, the largest offering since 2010 still outstanding, pay four times an adjusted spread between the five- and 30-year rates, capped at 9.25 percent, according to a prospectus filed with the U.S. Securities and Exchange Commission.

Morgan Stanley’s $50 million of 15-year notes linked to the two- and 30-year rates dropped to 107 cents on the dollar from 111 cents over the same period this month, Trace data show. The securities pay five times the difference between the short- and long-term rates, capped at 11 percent, according to a prospectus filed with SEC.

Bloomberg started collecting comprehensive data on SEC-registered securities in January 2010.

Tiffany Galvin, a spokeswoman for Goldman Sachs in New York, and Lauren Bellmare of Morgan Stanley, declined to comment on the securities.

Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts with values derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

To contact the reporter on this story: Kevin Dugan in New York at kdugan4@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Richard Bedard, Mitchell Martin

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