In a recent analysis, the UBS rates desk has put forward a strategic suggestion for clients who have positioned their portfolios with a steepening bias. Given the current financial landscape and the anticipation of policy actions by the European Central Bank (ECB), UBS proposes the inclusion of a specific derivative instrument to safeguard these investments.

This instrument is a 6-month 10s2s single-look curve floor with a strike of -0.50. What does this mean? Essentially, it’s an options-based strategy that allows investors to have a floor on the interest rate spread between the 10-year and 2-year yields. The strike of -0.50 indicates the level at which this option will provide payouts.

The remarkable aspect of this recommendation is the limited decay of the option’s value over a three-month period. Option decay, or theta, is a measure of the rate at which an option loses value as time passes. A limited decay implies that the option’s worth will not diminish quickly over time, which is particularly beneficial if the market does not move in the anticipated direction promptly.

This recommendation is especially relevant in light of the uncertainty surrounding the ECB’s timeline for interest rate cuts. If the ECB postpones rate cuts or the market perceives that such cuts may not occur as soon as expected, yield curves could flatten. In such a scenario, having a curve floor option would provide a form of protection against potential losses that could result from a flattening yield curve.

By adopting this approach, investors with a steepening bias in their portfolio would gain a protective measure against further yield curve flattening. It is a strategic move that reflects both the current economic indicators and the prudent management of portfolio risk. As with any investment strategy, investors are encouraged to consult with their financial advisors to ensure it aligns with their individual investment goals and risk tolerance.