An investor expecting a monetary policy tightening and short rates to increase more than long rates might adopt a “barbell” portfolio, with very short and very long bonds. This would be based on the premise that the combined performance of this “barbell” portfolio would be better than a “bullet” portfolio entirely of mid-term bonds. Yield curve strategists refer portfolio positioning as “butterfly” trades with the “wings” of a trade being the short and long components on the yield curve and the “body” as the middle portion of the trade. Yield curve strategies can span the whole “yield curve” or be limited to a certain term area such as mid-term bonds. An investor’s expected holding period is the length of time an investor plans to hold his investments in his portfolio. According to an investor’s risk profile and time horizon, they may decide to hold a security short-term before selling or to hold long-term (more than a year).

Therefore, buying a longer maturity bond will yield higher returns due to price gains, provided that it is held for a period less than maturity. Suppose, however, that the duration on the portfolio is constrained; e.g., the modified duration of the portfolio must be within 0.25 years of the modified duration of the benchmark. Lengthening or shortening the duration by 3 months won’t make much of a difference when there is a parallel shift, so we need to look beyond duration. As a trading strategy, riding the yield curve works best in a stable interest rate environment where interest rates are not increasing. Additionally, the strategy only produces excess gains when longer-term interest rates are higher than shorter-term rates.

Yield Curve Strategies: Evaluating Bond Yield

Riding the yield curve (rolling down the yield curve) is an active trading strategy where a bond trader buys bonds with a maturity longer than their investment horizon. In an upward sloping curve, bonds with longer maturities earn higher yields relative to shorter maturities. Therefore, a longer maturity bond is valued at a successively lower yield and, thus, a higher price as it approaches maturity.

Personally, I prefer to think of steepening as a rotation counterclockwise (or anticlockwise, or widdershins), and flattening as a rotation clockwise (or deasil).

How Riding the Yield Curve Works

To take advantage of that fact, if the yield curve is normal (i.e., upward sloping), you can purchase bonds whose maturity is longer than your expected holding period, with the intention of selling those bonds at the end of the holding period. If interest rates change by the same amount for all terms of bonds, the yield curve is said to have had a “parallel shift”. When the difference between short- and long-term interest rates increases, the yield curve is said to “steepen”; when the difference between short- and long-term rates decreases, the yield curve is said to “flatten”.

• If rates rise, then the return may be less than the yield that results from riding the curve and could even fall below the return of the bond that matches the investor’s investment horizon, thereby, resulting in a capital loss.
• For example, the rate of a one-year bond is lower than the rate of a 20-year bond in times of economic growth.
• Personally, I prefer to think of steepening as a rotation counterclockwise (or anticlockwise, or widdershins), and flattening as a rotation clockwise (or deasil).

This strategy is used in order to profit from the normal upward slope in the yield curve caused by liquidity preferences and from the greater price fluctuations that occur at longer maturities. Nonetheless, riding the yield curve is always risky because there can be no guarantees that the yield curve will remain unchanged over time. Additionally, riding the yield curve will not be as profitable as the buy and hold strategy when the interest rates rise.

Riding the Yield Curve

Convexity is used as a measure of how duration and price sensitivity changes over a range of interest rate scenarios. Managers are said to be “buying convexity” when they shift into higher convexity bonds and possibly reducing their portfolio yield. Riding the yield curve is only more profitable than the classic buy-and-hold strategy if interest rates stay the same and do not increase. If rates rise, then the return may be less than the yield that results from riding the curve and could even fall below the return of the bond that matches the investor’s investment horizon, thereby, resulting in a capital loss. For example, the rate of a one-year bond is lower than the rate of a 20-year bond in times of economic growth. When the term structure reveals an inverted yield curve, this means short-term yields are higher than longer-term yields, implying that investors’ confidence in economic growth is low.

If the upward sloping yield curve shape and level remain unchanged over the investment horizon, riding the yield curve will generate higher returns than a maturity matching strategy. The higher the difference between the forward rate and spot rate, the higher the total return. Taking the long position in bond futures will increase the duration of your fixed income portfolio. However, if your view is that the yield curve will remain static, that increased duration will not be an issue as far as your return is concerned. It may be an issue if your portfolio has a duration constraint (as was mentioned in the rolling-down-the-yield-curve strategy, above).

In what follows, we focus on the yield curve, which represents the term structure of interest rates for government or benchmark securities, with the assumption that all promised principal and interest payments take place. Fixed-income securities, which trade at a spread above the benchmark to compensate investors for credit and liquidity risk, will be addressed later in the curriculum. The starting point for active portfolio managers is the current term structure of benchmark interest rates and an interest rate view established using macroeconomic variables introduced earlier. In what follows, we demonstrate how managers may position a fixed-income portfolio to capitalize on expectations regarding the level, slope, or shape (curvature) of yield curves using both long and short cash positions, derivatives, and leverage.

Financial Exam Help 123

Because of the convexity, all of the portfolios under the 75 bps downward shift have a higher value than that, with the bullet having the lowest value and the barbell the highest; again, as expected. Because of the convexity, all of the portfolios under the 50 bps upward shift have a higher value than that, with the bullet (least convex)  having the lowest value and the barbell (most convex) the highest, as expected. Riding the yield curve is a trading strategy that involves buying a long-term bond and selling it before it matures so as to profit from the declining yield that occurs over the life of a bond. For example, an investor with a six-month investment horizon may buy a one-year bond because it has a higher yield; the investor sells the bond at the six-month date but profits from the higher one-year yield. Once again, mind any duration constraints, and make sure that the net result doesn’t violate those constraints.

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A yield curve strategy would position a bond portfolio to profit the most from an expected change in the yield curve, based on an economic or market forecast. This illustrates one strategy that you can employ when you think that the yield curve will be static for your expected holding period; it’s called riding the yield curve. If you have duration constraints, you’ll have to adjust the exposures so that the net result doesn’t violate those constraints. And note that while futures, forwards, and options on long-term bonds are fairly common, futures, forwards, and options on short-term bonds may be much less common, so these strategies may be difficult or impossible to implement in practice. Duration is used as a measure of a portfolio’s sensitivity to a change in interest rates.

It will be a lot easier to analyze than rolling over an overnight repo every day for two years. The size and breadth of global fixed-income markets, as well as the term structure of interest rates within and across countries, lead investors to consider numerous factors when creating and managing a bond portfolio. While fixed-income index replication and bond portfolios that consider both an investor’s assets and liabilities were addressed earlier in the curriculum, we now turn our attention to active bond portfolio management. In contrast to a passive index strategy, active fixed-income management involves taking positions in primary risk factors that deviate from those of an index in order to generate excess return. Financial analysts who can successfully apply fixed-income concepts and tools to evaluate yield curve changes and position a portfolio based upon an interest rate view find this to be a valuable skill throughout their careers. When riding the yield curve, an investor will purchase bonds with maturities longer than the investment horizon and sell them at the end of the investment horizon.