How do you structure a credit curve steepener trade and when is it profitable?

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AcadiFi · Accepted Answer

A credit curve steepener profits when the spread difference between long-dated and short-dated CDS widens. You sell prot...

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**Trade structure:**

- **Sell** 2-year CDS protection at 60 bps (collect premium, short credit risk near-term)
- **Buy** 10-year CDS protection at 120 bps (pay premium, long credit risk long-term)
- **Net carry:** Negative (you pay 120 bps, receive 60 bps = -60 bps net)
- **Profit when:** The 10y-2y spread widens beyond the carry cost

**Duration-weighted (DV01-neutral) implementation:**

Since 10-year CDS has higher duration than 2-year, you need smaller notional on the 10-year leg to equalize the spread sensitivity:

| Leg | Tenor | Spread | DV01 per $10M | Notional |
|---|---|---|---|---|
| Sell protection | 2-year | 60 bps | $1,800 | $10M |
| Buy protection | 10-year | 120 bps | $8,200 | $2.2M |

DV01-neutral means a parallel shift in the credit curve produces zero P&L -- you only profit from curve shape changes.

**When to use this trade:**

1. **Deteriorating long-term fundamentals** -- Company's business model faces secular headwinds, but near-term cash flows are stable
2. **Approaching credit event risk** -- Long-term investors demanding higher compensation for uncertain recovery
3. **Rating downgrade trajectory** -- Company on negative watch; short-term obligations covered by liquidity but long-term debt sustainability in question

**Example -- Arbor Communications (fictional):**
Arbor is a legacy telecom with stable subscription revenue (2-year CDS at 80 bps) but massive capex needs for 5G rollout funded by debt (10-year CDS at 180 bps). If management announces further debt issuance, the 10-year spread widens to 230 bps while the 2-year barely moves -- the steepener profits on the 50 bps curve widening.

How do you structure a credit curve steepener trade and when is it profitable?

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