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.
Spokespeople at the banks declined to comment on the impact of the yield curve on the notes.
While banks issue the debt securities, 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.
Pederson said the buyers in question are prevented from discussing the cases thanks to non-disclosure agreements.
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. A spokesperson for Goldman declined to comment on the product.
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.
Banks warn in the prospectuses for the notes that they may pay no interest if the spread between short- and long-term rates moves to zero. They also caution that the returns buyers earn can be lower than those available from traditional debt securities paying interest at prevailing market rates.
Investors in some of the notes even put their principal at risk, as banks issued securities stripped of capital protection amid demand for juicier coupons. FINRA was already warning back in 2014 of the growing number of steepener notes without such safeguards.
“With the continuing low-rate environment, issuers are becoming even more creative with the products they offer, and we continue to see more bells and whistles added to already complex products,” Susan Axelrod, the body’s executive vice president for regulatory operations at the time, said in a speech that year.
For instance, recent notes sold by banks link the floating-rate leg to both the difference between short-term and long-term swap rates and the levels of one or more equity benchmarks, such as the S&P 500 and Russell 2000 indexes. At maturity, if one of the equity indexes is down by more than a certain amount, investors can get around half their principal back, or less.
“It would be extremely difficult to understand this product even after spending a lot of time with it,” said Craig McCann, principal at Securities Litigation & Consulting Group, which works with plaintiffs in securities litigation. “Valuing it would be a completely higher level of difficulty.”
While the difference between two- and 10-year Treasury notes has climbed over the past week to 51 basis points, the gap isn’t far off decade lows.
And the curve looks unlikely to morph into a shape more favorable to investors who snapped up steepener products at par. Strategists from UBS Group AG to Morgan Stanley are projecting the gap will effectively vanish soon enough.
Between the Federal Reserve’s tightening stance, stable long-term inflation expectations and technical factors like rising short-dated Treasury issuance, an inverted yield curve may also be on the cards, strategists at JPMorgan have warned.
While that would constitute an ominous sign for growth, holders of these structured products don’t have to worry about their interest rate turning negative: the coupons are typically floored at zero. And investors may find there’s a bid for their beaten-up securities from bargain hunters, particularly in light of recent curve steepening.
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