The changing shape of the interest-rate curve might do what terrorist attacks, a war, and an economic slowdown could not: slow down Wall Street’s bond profit machine.

As major equity indices have been inconsistent performers for the past several years – the S&P 500 is up 0.01% this year – and mergers and acquisitions have only begun to emerge from a multiyear slumber, the profits generated by the relatively steep shape of the interest-rate curve by Wall Street dealers’ bond desks helped many firms maintain profitability.

Now, analysts and the Street’s bond executives are wondering what happens when all of the money dedicated to various bond trades has to be rerouted to more profitable strategies.

The yield curve, or the measurement of various U.S. Treasury rates from two-to 30-years, has been “steep” for the past three years, with a broad difference between two-year and 10- and 30-year rates, usually referred to as the “longer end” of the curve. This difference allowed dealers to borrow extensively at the short-end of the curve, take the proceeds and buy large amounts of longer-dated bonds that pay a higher rate of interest. The difference between the two rates is profit to the dealer.

This strategy, known as “the carry trade,” was most popular with hedge funds and dealer proprietary trading desks, which have used leverage provided by Wall Street dealers and banks to expand their positions. “There was a lot of ‘hot money’ selling short and buying long over the past two or three years. Now, a lot of that money is getting ready to get out of the trade,” said Bianco Research’s James Bianco. Mr. Bianco, whose firm provides independent bond-market research to institutional money managers and hedge funds, said the problem is that most of these money managers tend to operate in a similar fashion. “A stampede for the door is a very real threat when we are talking about tens of billions of dollars exiting out of a trade in a short period of time.”

Another factor to consider, said the Chicago-based Mr. Bianco, is that Wall Street’s dealers have reconfigured their balance sheets to be “bond-oriented.” What this means is that dealers went from having about $250 billion in Treasury and Agency securities on their balance sheets in 1995 to $850 billion at the end of 2004, according to the Federal Reserve Bank of New York’s Web site.

Another independent analyst, Credit-Sights’s David Hendler, said the shifting yield curve would ordinarily have disastrous effects upon large dealers, but for a pair of saving graces: The re-emergence of an initial public offering market and M&A activity. “Some of the firms that have over 50% of their bottom line coming from bonds will be OK, since they can start pulling $20 million fees for three weeks work on mergers again,” said Mr. Hendler. He said Goldman Sachs and Morgan Stanley are especially well positioned for the packed IPO calendar and spate of mega-mergers.

With the curve so steep, profit is exactly what many dealers were doing in a big way. The income earned at Bear Stearns and Lehman Brothers, two of the strongest bond trading firms on the Street, is an example of just how crucial bond markets are to the firms’ financial health. Through August 31, according to its Securities and Exchange Commission 10-Q filing, Bear Stearns’s made $2.41 billion trading and selling bonds, out of a total of $3.92 billion in total capital markets revenue for the firm. In the same period for Lehman Brothers, $9.5 billion out of the firm’s $12.5 billion in securities trading, sales, and underwriting revenue came from fixed-income. With all the bond-trading profits falling to its bottom line, investors have pushed Bear Stearns stock price to $104.05, an all time high for the 80-year old firm.

A senior bond executive at Bear Stearns said the shift would probably not be a rout – like 1998’s market crisis, brought about by the collapse of the Long-Term Capital Management hedge fund – but an evolution. “Profitability is dropping across all areas of the bond market, but is not collapsing. If no events occur, the transformation to deals and IPOs as profit movers will be complete within the next few months,” he said.