Assessing the 2013 outlook for U.S. Treasuries is proving to be a challenge as the year draws to a close. On one hand, short-term government bonds are unlikely to provide much return, but they're equally unlikely to collapse given the Federal Reserve's pledge to keep short-term interest rates near zero. On the other hand, however, yields on longer-term Treasuries are so low that any whiff of inflation or stronger economic growth is likely to weigh heavily on the 10- and 30-year issues. (Keep in mind, prices and yields move in opposite directions.)
How can an investor capitalize on this possibility? One way is to take a look at the iPath US Treasury Steepener ETN (ticker:STPP). The fund has only $7.5 million in assets, which puts it in the bottom 15% of bond exchange-traded products in terms of its size. However, it offers a unique way to bet on the changing "shape" of the yield curve. (The "yield curve" is simply the yield of each bond along the maturity spectrum plotted on a graph, as shown here).
When the yield curve steepens, the gap between the yields on short-term bonds and long-term bonds widens, making the curve appear steeper. An increase in this gap indicates that yields on long-term bonds are rising more than yields on short-term bonds. STPP seeks to take advantage of this by holding a portfolio that is designed to rise in value if the yield on the 10-year note climbs faster than the yield on the two-year note. Conversely, STPP falls in price if the yield curve flattens. That's just what has happened in 2012: the yield on the two-year held steady at the same time as the yield on the 10-year declined modestly, resulting in a flatter yield curve and causing STPP to lose 13.7%.
These results should make it apparent that this fund is a risky proposition that isn't appropriate for everyone. However, for seasoned investors who don't mind some volatility, STPP might prove to be a good choice if Treasury yields indeed begin to rise in 2013.