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‘Steepener’ Structured Notes Rebound on Rate Concerns

Sales have rebounded of U.S. structured notes that gain when the gap grows between interest rates of different maturities, as investors seek protection from an eventual rise in long-term rates.

Banks sold $161.2 million of the securities this year, 8 percent more than in all of 2012, according to data compiled by Bloomberg. The notes are called “steepeners” because they pay more if the difference between long- and short-term rates increases.

Investors who hold long-term debt, the value of which would be eroded if rates went up, are using the securities as a hedge, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia. Risks related to rates, such as the threat of increases if the Federal Reserve stops buying long-term securities, “are higher than they’ve been at any time,” he said.

“A steepener would perform well in periods of long-term rising interest rates,” LeBas said.

Potential profits from investing in steepeners would be threatened if short-term interest rates surged though.

The Federal Open Market Committee reiterated in January that it would keep the federal funds target rate between zero and 0.25 percent as long as inflation isn’t forecast to rise to more than 2.5 percent and unemployment stays above 6.5 percent.

The five-year U.S. breakeven rate, which measures expectations of inflation, rose to 2.38 percent yesterday from 2.07 percent on Jan. 1.

The Federal Reserve acted to constrain rates last year. In September, it announced an open-ended program of buying $40 billion of long-term mortgage debt a month.

Maximum Coupon

Last year, banks didn’t sell any steepeners between May 1 and Oct. 25, Bloomberg data show.

All except for one of the U.S. securities issued this year are tied to the difference between the 30-year and five-year rates for constant-maturity swaps, which measure the cost of exchanging floating and fixed interest rates, Bloomberg data show. Last year, 69 percent of issuance for the notes was linked to 30-year and two-year rates.

The five-year swap rate is now more volatile than the two-year because the Fed is unlikely to raise the benchmark rate in the next two years and its bond-buying program, known as quantitative easing, will probably end well before that, said Brett Rose, head of U.S. rates strategy at Citigroup Inc. in New York.

This year’s steepeners pay as much as 10.25 percent annually before switching over to the spread between the rates, which may be leveraged four or five times, Bloomberg data show.

Largest note

Goldman Sachs Group Inc. sold $64 million of 15-year securities on March 1, the largest such offering since Sept. 17, 2010. The notes yield 9.25 percent for the first year before switching to a formula-based rate, according to a prospectus filed with the U.S. Securities and Exchange Commission.

The calculated rate is four times the spread between the five- and 30-year rates, minus 0.2 percent and capped at 9.25 percent. The notes can be called after six months. The bank valued the securities at 93.8 cents on the dollar at issuance and distributed them for a 2.9 percent fee.

Tiffany Galvin, a spokeswoman for Goldman Sachs, declined to comment on the security.

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 whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

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