Welcome to Yield Curve Strategies!
Hello! If you’ve made it to CFA Level III, you already know that bonds are about more than just collecting interest. In this chapter, we explore how portfolio managers "play" the yield curve to boost returns. Think of the yield curve as a roadmap of interest rates. By predicting how that roadmap will change—or even by assuming it stays exactly the same—we can position our portfolios to win. Don’t worry if this seems a bit abstract at first; we’re going to break it down into simple, manageable steps.
1. When We Expect a Stable Yield Curve
Sometimes, we believe interest rates aren't going to move much. If our "view" is that the yield curve will remain unchanged, we have three main strategies to consider. The goal here is to maximize "yield" and "roll-down" return.
A. Buy and Hold
This is the simplest strategy. You buy bonds with a higher yield than your benchmark and simply hold them. By choosing bonds with longer maturities (which usually offer higher yields), you generate excess return through higher coupon income. Analogy: It’s like picking the savings account with the highest interest rate and just letting your money sit there.
B. Rolling Down the Yield Curve
If the yield curve is upward-sloping, a bond’s price naturally increases as it gets closer to maturity (assuming its yield stays on that upward-sloping path). This is because as time passes, the bond is priced at lower and lower market yields.
The Math: Total Return = Yield + Capital Gain from "rolling down."
Quick Tip: This strategy works best when the curve is steep. The steeper the slope, the faster the "roll down" and the bigger the price gain!
C. The Carry Trade
This is for the more adventurous manager. In a carry trade, you borrow money at a low short-term rate and invest it in a higher-yielding long-term bond.
Did you know? This is often done using Repurchase Agreements (Repos). You are essentially using leverage to magnify your returns. However, if short-term rates rise unexpectedly, your borrowing costs could eat up all your profits!
Key Takeaway: If you think the curve won't move, go for higher yield, roll-down, and leverage (carry trades).
2. Managing Duration and Yield Curve Shifts
When we expect interest rates to change, we move away from just "collecting yield" and start managing Duration. Duration measures how sensitive a bond's price is to a change in interest rates.
A. If you expect rates to FALL:
You want to be long duration. When rates fall, bond prices rise. The higher your duration, the more your portfolio value will jump.
Mnemonic: Rates Down, Duration Up (RDDU).
B. If you expect rates to RISE:
You want to be short duration. You want to minimize the "hit" your portfolio takes when prices drop. You might even move into cash or very short-term notes.
C. Parallel vs. Non-Parallel Shifts
A parallel shift means rates for all maturities move up or down by the same amount. If you expect a parallel shift, you only care about your portfolio's total Money Duration (or Basis Point Value - BPV).
Quick Review:
- Expect lower rates? Increase Duration.
- Expect higher rates? Decrease Duration.
- Common mistake: Forgetting that duration works both ways! High duration is great when rates fall, but painful when they rise.
3. Bullet, Barbell, and Butterfly Strategies
What if the curve doesn't move in a straight line? What if it "twists" or "bends"? We use three main structures to handle these movements:
A. The Bullet
You concentrate your maturities around a single point on the curve (e.g., all 10-year bonds).
Use this: When you expect that specific part of the curve to perform best.
B. The Barbell
You invest in very short-term and very long-term bonds, but nothing in the middle.
Use this: When you want high convexity or expect the curve to "flatten."
C. The Butterfly Trade
This is a combination of a Bullet and a Barbell. It’s used to bet on the curvature of the yield curve.
- Long the Butterfly: You buy the "wings" (Barbell) and sell the "body" (Bullet). This benefits from the curve becoming more curved (more humped).
- Short the Butterfly: You buy the "body" (Bullet) and sell the "wings" (Barbell). This benefits from the curve becoming less curved (flatter).
Simple Trick: Think of a physical butterfly. The body is the middle (Bullet), and the wings are the ends (Barbell).
- Body = Bullet (Intermediate term)
- Wings = Barbell (Short & Long term)
Key Takeaway: Barbells have more convexity than Bullets of the same duration. If you expect high volatility in rates, you want more convexity (Barbell)!
4. Changing Curve Slopes: Steepenings and Flattenings
Managers often trade based on whether they think the spread between long-term and short-term rates will grow or shrink.
A. Curve Flattening
This happens when the gap between long-term rates and short-term rates gets smaller.
Strategy: To profit, you want to be "long" the long end. You would buy long-term bonds (increase duration) because long-term rates are falling relative to short-term rates.
B. Curve Steepening
This happens when the gap between long-term and short-term rates gets wider.
Strategy: You want to be "short" the long end. You would sell long-term bonds or reduce duration because long-term rates are rising faster than short-term rates.
Step-by-Step Explanation for a Flattener:
1. You predict long-term rates will fall toward short-term rates.
2. You buy 30-year bonds (Long Duration).
3. Rates fall, the price of your 30-year bonds jumps significantly.
4. You sell for a profit!
5. Using Derivatives to Implement Strategies
Sometimes buying actual bonds is expensive or slow. Managers use Interest Rate Swaps or Futures to change their yield curve exposure quickly.
1. Receive-Fixed Swap: This is like buying a bond. It increases your duration. You profit if interest rates fall.
2. Pay-Fixed Swap: This is like shorting a bond. It decreases your duration. You profit if interest rates rise.
3. Bond Futures: Buying futures increases duration; selling (shorting) futures decreases duration.
Important Note: When using derivatives, we often talk about Key Rate Durations. This allows us to see how sensitive the portfolio is to a change in a specific point on the curve (like the 5-year rate) rather than just the overall parallel shift.
Summary: The Cheat Sheet
1. Stable Curve? Maximize yield, roll-down, and use carry trades.
2. Rates going UP? Shorten duration, use Pay-Fixed swaps.
3. Rates going DOWN? Lengthen duration, use Receive-Fixed swaps.
4. Expecting high volatility? Choose a Barbell (high convexity).
5. Expecting a Flattener? Go long the long-term bonds.
6. Expecting a Steepener? Go short the long-term bonds.
Don't worry if the Butterfly trades feel complex. Just remember: Positive Butterfly means the curve is becoming less humped (the wings outperform the body). If you can remember that the Barbell provides the wings and the Bullet provides the body, you are halfway there!