Yield Curve Strategies for a Static Yield Curve

Active management doesn't mean trading all the time. It means using judgement about certain market conditions and acting accordingly. Sometimes, your best guess might be that the yield curve won't move much.

If you're really expecting little or no movement in the yield curve, what basic strategy comes to mind?

Probably not. Bonds tend to lose a little value as they become off the run. This would continually trade lower-priced bonds for higher-priced bonds.

Absolutely. You might just "set it and forget it." If there's not going to be a change, buy some good securities (probably with longer durations), and wait. Simple enough.

Not so. That's not fair to your client; don't consider that for a moment.

But it might also depend on the shape of that yield curve you expect will stay still. If it's upward sloping, then that means a bond with a longer time to maturity should have a higher yield. So as a three-year bond becomes a two-year bond, what happens to the price?

Exactly!

No, it'll go up.

As time to maturity shortens, the bond will take on the lower yield of those shorter-term bonds today. So since lower yields mean higher prices, you can gain in terms of price appreciation just by holding onto bonds for a while. That's called riding the yield curve, or rolldown, as the bond rolls down that upward-sloping curve to time zero.

On what sort of curve would this work best, do you think?

No. This doesn't work for inverted curves. The opposite would happen: price decline.

Yes! So the goal would be to use the steepest part of the yield curve to obtain the best "roll" during this time. And the time here is an important point, because otherwise this just sounds like more of the buy-and-hold strategy. This is specifically looking at a purchase for a time horizon to take advantage of the rolldown that is expected to occur if, again, the yield curve stays in place like you expect.

No. Nothing rolls on a flat surface.

You might also consider a "repo carry" trade. It seems a little off topic, since this is usually a currency trick, but that currency has to buy something. Here, it could be part of your fixed-income portfolio. Recall that the carry trade is borrowing in a low-interest rate currency and then investing in a bond in a higher-yielding currency. That's an inter-market carry trade. Basically, there are three ways to implement this trade. First, you can borrow from a bank in the lower rate currency, convert the proceeds to the higher rate currency and invest in a bond denominated in that currency. Second, you can enter into a currency swap, receiving payments in the higher rate currency and making payments in the lower rate currency. Third, you can borrow in the higher rate currency, invest the proceeds in a similarly denominated security, and convert the financed position to the lower rate currency via the forward market. Parity conditions suggest that the exchange rate should change to destroy your profits, but empirically it doesn't quite change enough to do that. So you can pick the most favorable maturity on each side of the trade. But what would happen if the currency you borrowed in appreciated?

Right.

No. Actually it wouldn't work as well. Consider that the debt you have in that foreign currency has gotten relatively more expensive now.

Again that's what's supposed to happen, but that change tends to be too small. So there's a potential for profits. And, there are also three ways to set up an intramarket (meaning single currency) carry trade to take advantage of a stable, upward-sloping yield curve. First, you can buy a bond and finance it in the repo market. That's basically creating an asset and a liability. Second, you can receive fixed and pay floating on an interest rate swap, which essentially replicates the cash flows of an asset and liability. Third, you can take a long position in a bond (or note) futures contract. Essentially, as traders arbitrage the relationship between the spot and futures prices, the return on these trades will be like earning accrued interest on a bond and paying financing costs.

Finally, you could trade convexity, in a way (or in several ways). Convexity is great for helping bond prices stay higher when there's volatility. But if you are expecting a steady, static yield curve, you don't really have any use for that convexity. So sell it. You can make some money. You could do this by selling or shorting a short-term and long-term bond together, which is a __barbell portfolio__, such that the average duration is say, 10. Then buy that single maturity of 10-year bonds only, which is a __bullet portfolio__. You get the same duration exposure back, but you've sold the convexity.

For another example, if rates were expected to move a lot, what sort of bond would be best for you to have as an investor?

Sure. Putable is good for you, straight is neutral, and callable is good for the issuer. So the yields reflect that. Volatility makes those options valuable and makes the callable bond have a higher yield and the putable bond have a lower yield.

No. There's no option in those that benefits you.

No. That's what the issuer would want.

So everyone is trading these bonds, expecting volatility, but not you. You think the yield curve is going to hold very still for a while. Then what type of bond would you want to hold?

Probably not. Consider that the yield of this bond will be low, and the put isn't expected to have value, anyway.

Not really. This bond won't have the highest yield. But if you're right, and things hold steady, then all of these bonds will ultimately pay the cash flows of a straight bond.

Exactly! If you're right, and everything stays still, then these are all essentially like straight bonds in terms of cash flows. The convexity of the bonds is what gives them different values, but if there's no change in yields, convexity doesn't matter, and so you might as well grab the highest-yielding bond you can. By purchasing a callable bond, you have essentially sold a call option that you expect to expire worthless. There's where your extra yield comes from, and selling that option is selling volatility and selling the resulting convexity. Sell puts, sell bonds, sell all the convexity you can, assuming you're right about that yield curve staying in place. Be careful—historically it hasn't done that for very long.

To summarize: [[summary]]

Churn daily

Buy and hold

Sell off the runs for on the runs

It goes up

It goes down

Flat

Steep

Inverted

It wouldn't work as well

It would work even better

Putable

Straight

Callable

Putable

Straight

Callable

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