Narrowing of Swap-Rate Spread Endangers U.S. ‘Steepener’ Notes

U.S. structured notes that make payments based on the difference between short- and long-term rates are declining in value after the biggest drop in the spread in more than a year and a half.

The gap between five-year and 30-year constant maturity swaps narrowed 13.7 basis points to 185.13 on June 19, after Fed Chairman Ben S. Bernanke announced that the Federal Reserve may begin reducing its $85 billion a month in bond purchases as long as the U.S. economy performs in line with the central bank’s projections.

A compression in the spread is pushing down the value of so-called steepener notes that pay more if the difference between long- and short-term rates increases. Banks have sold $449.2 million of securities tied to the five- and 30-year constant maturity swap-rate spread this year, making it the most popular type of steepener, according to data compiled by Bloomberg.

The rate for five-year swaps climbed more than that for the 30-year because a decline in inflation expectations in the last six weeks or so has limited the rise for long-term rates more than for short-term, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia.

The difference between the two swap measures shrank the most in percentage terms since Sept. 22, 2011. That day, the Federal Reserve announced Operation Twist, a plan to drive down long-term bond yields by selling short-term debt and buying long-dated debentures.

Largest Note

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

Investors receive four times the spread between the five-and 30-year rates after subtracting 0.2 percent, with returns 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.

The notes traded for 97 cents on the dollar yesterday, 2.5 cents less than on June 10, the most recent prior day they changed hands, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

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

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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