Yield Curve Notes

Yield curve note definition


A yield curve note is a fixed maturity variable rate debt security that inversely reflects the movement of interest rates. When interest rates increase, the yield of a yield curve note decreases, and vice versa. As a result, yield curve notes are in high demand by investors for use as hedges against interest rate movement in the general debt security market.

Yield curve note history


Yield curve notes were first introduced in February 1986. Featuring a floating interest rate, these new debt securities soon gained in popularity and within two months had achieved almost $1 billion in new investment, largely due to their utility in providing a hedge against major downturns in the overall market interest rate. Yield curve notes typically are issued by major financial institutions and are designed to be very sensitive to interest rate shifts, making them a highly volatile investment. However, because their yield varies inversely with overall interest rate movement, yield curve notes provide an offsetting value in the event that other interest-rate based investments lose value due to a gradual or sudden decrease in the interest rate.

Applications


Yield curve notes are sometimes referred to as bull floating rate notes, or bull FRNs, because even though they depend upon a downturn in interest rates and, by extension, the stock market in order to achieve profitability, investors anticipate an upturn in the yield of the bonds being purchased and an increase in the yield curve note’s coupon rate. Yield curve notes often incorporate a leverage aspect, allowing them to increase profits disproportionately in comparison with a downward shift in the market interest rate; this makes them an attractive prospect for investors who wish to offset potential losses in the event that interest rates experience a significant decrease. Because yield curve notes are directly tied to the market interest rate, they offer outstanding risk protection in this regard.

Conclusions


While yield curve notes allow investors to hedge against downturns in the interest rate and offer better-than-average risk protection, they can represent an unacceptable opportunity cost during extended periods of growth. For most investors, yield curve notes represent a temporary hedging measure rather than a long-term strategy for growth.
Tim Ord
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