There is an alternative way to benefit from a steepening credit curve. If an investor expects issuer A’s credit curve to steepen more than implied by forward spreads and issuer B’s credit curve to flatten at the same time, he could switch from company A’s long bonds into company B’s long bonds. Whenever company B has a bond outstanding with a longer maturity than the bond that is sold, the trade can be set up on a durationneutral basis. Crabbe and Fabozzi (2002) point out that the return from this strategy over a 1-year horizon is approximately equal to
Return = spread differential – duration * change in spread differential, assuming roughly equal durations for both bonds. But it should be noted that this trade is not a pure bet on an issuer’s credit curve. Even if the credit curves behave as expected and the trade turns out to be profitable, taking another position may have been more beneficial in absolute terms and with respect to the individual credit curves of the two involved issuers. This is true, for example, if the spreads of company A and B widen significantly across their credit curves. In this case the capital loss due to the spread widening can exceed the profit of the bond swap. Being positioned at the short end of the credit curve then would have been a better strategy from an absolute return perspective.
