What are flattening and steepening yield curve trades, and when would I use each?

Yield curve trades are among the most common fixed income strategies. They involve taking positions at different points on the maturity spectrum to profit from changes in the yield curve's shape.

Two Types of Curve Shifts

Flattening Trade: Long the long end, short the short end

If you expect the curve to flatten (the gap between long and short rates narrows), you:

• Buy long-duration bonds (benefit from falling long rates)
• Sell/short short-duration bonds (profit from rising short rates)

Example — Flattening Trade with Larson Capital Portfolio:

You believe the Fed will hike short-term rates while inflation expectations decline, pulling long rates down.

The notional is adjusted so dollar duration is equal on both legs (duration-neutral): 8.5 x $10M = 1.9 x $44.7M = $85M dollar duration.

If the 10y yield falls 30 bps and the 2y yield rises 20 bps:

• Long leg: +$10M x 8.5 x 0.003 = +$255,000
• Short leg: +$44.7M x 1.9 x 0.002 = +$169,860 (short profits from rate rise)
• Total P&L: +$424,860

Steepening Trade: Long the short end, short the long end

The opposite — profit when the curve steepens (gap widens). You might use this when expecting rate cuts (short rates fall faster than long rates).

Risks to Watch:

1. Parallel shifts — If rates move in parallel, both legs are affected similarly and the trade produces little P&L (if properly duration-matched).
2. Carry cost — The short bond position may have negative carry if you're paying the coupon.
3. Butterfly risk — The middle of the curve moves differently than either end.

Bear Flattener vs Bull Flattener:

• Bear flattener: Short rates rise faster than long rates (Fed hiking)
• Bull flattener: Long rates fall faster than short rates (recession fears)

Both result in a flatter curve, but the overall rate direction differs.

Exam Tip: CFA Level I questions may describe a macro scenario and ask which curve trade is appropriate. Match the expected curve change to the right position.

Practice yield curve strategies in our CFA Fixed Income question bank.