Credit Flattener and Steepener: Duration and Convexity Exposures

Flattener/Steepener are long/short strategies that bet on the relative movements of long vs. short maturity ends on a curve. The curve can be interest rate, variance or credit spread. For the sake of discussion, we consider a credit spread flattener.

The three main exposures are TIME, CURVE SHIFT and DEFAULT. Here we focus on CURVE SHIFT. Surely, we can mitigate the risk by duration hedging (even so we will be left with convexity risk, see below). However, notional matching has the advantage of zero default exposure (at least until the shorter leg expires).

In a notional-matched flattener, the investor speculate on flattening credit curve by selling (buying) CDS protection at the long (short) end. If the curve steepens instead, we would of course have a loss. What if the curve tightens by a parallel shift?

The mark-to-market as the spread moves is calculated by multiplying spread change to risky DV01, which, to recap, is the CDS spread numeraire. Obviously, DV01 of longer leg > DV01 of shorter leg. Hence a parallel upward shift (widening) of the curve affects the long leg more. But widening spread is bad for protection seller. Therefore a flattener position is harmed by widening spread (because the benefit on the short end < the loss on the long end).

The previous paragraph assumes that DV01 remains constant when the shift is small enough, and it considers only the relative sizes of DV01's. Not surprisingly, DV01 itself does not stay constant as the curve shifts further and hence there is convexity effect, which concerns the relative sensitivities of DV01's. Turns out DV01 decreases as spread widens, and the DV01 of the long end is more sensitive to curve shift than the short end. It follows then, that a flattener has positive convexity (when spread widens => DV01 drops => bad effect at long end diminishes => good for investor) while steepener has negative convexity.

Reference: JP Morgan 'Credit Derivatives Handbook'