Flattening Yield Curve Bond Play

This question is about expressing a view on the shape of the Treasury yield curve while holding a specific credit spread constant. The setup contrasts a five-year corporate zero-coupon bond with default risk against a risk-free government yield curve built from coupon Treasuries. The candidate is told to assume that short and long rates will move in opposite directions, but that the five-year point, including the corporate spread over Treasuries, will stay where it is. The task is to choose a trading position involving the risky zero and appropriate Treasury instruments that will profit if the curve flattens as anticipated.

The problem leans on term structure intuition, duration, and curve-flattening trades commonly discussed in fixed income and macro trading interviews. It expects familiarity with how to isolate exposure to changes in the yield curve's shape, separate from both overall rate level and credit risk. An interviewer will watch for clear reasoning about key rate durations, long–short construction, and how to neutralize unwanted sensitivities so that the trade primarily reflects the candidate's stated macro view.

What it tests

The core structure in this class of problems is the separation of yield curve risk from credit (default) risk using duration-matched portfolios. Bonds with the same duration have similar sensitivity to parallel shifts in interest rates, regardless of their coupon structure or issuer. By constructing portfolios that are long and short bonds of equal duration but different credit qualities, you can neutralize interest rate risk and isolate exposure to credit spreads. This principle holds because duration-matching ensures that the price impact from small interest rate changes is offset between the long and short positions, leaving only the relative movement in credit spreads or curve shape as the source of profit or loss. The underlying pattern is to use hedging to control for systematic risk factors (like interest rates) and focus exposure on the specific risk premium you want to exploit.