Yield Curve Strategies for Changes in Slope or Curvature
Choosing duration is one thing. How you accomplish that is another.
For example, you can build a bond portfolio with a duration of 10 by either choosing 10-year zeros in a bullet portfolio or by setting up a barbell of short-term securities and some 20-year or even 30-year bonds. While the duration is the same, convexity is not. What type of yield curve change do you think could cause these portfolio values to move in different directions?
Of course.
No.
With the same duration, a shift in the yield curve will affect both portfolios in a similar manner, as long as the shift is small. But a steepening of the yield curve would have very different effects.
A steeper yield curve would hurt the long-term bonds a lot more than the 10-year bonds, and so this just underscores the difference that dispersion can make in a portfolio. Again, more dispersion means more convexity, and convexity makes the "up" movements better and the "down" movements better when yields change. How do you think that affects the yields of higher-convexity bonds?
Absolutely!
No.
Actually, they have lower yields.
Since convexity is a positive adjustment, helping bonds to have higher prices wherever yields move, market prices respond appropriately to give these bonds lower yields. So there's a tradeoff.
Now, take that idea to the mind of an active manager. Suppose that you were managing a portfolio, and your market research suggests that the yield curve is about to move quite a bit in odd ways. How might you take advantage of these expectations with convexity?
That's right.
Convexity is more valuable in this situation than is priced by the market, so buy it. Buying convexity could mean buying options or selling callable bonds since the option value would be underpriced (again, assuming that you're right), or just exchanging some bullet parts of your portfolio for more of a barbell.
Not really.
Obviously you could do more with more information, but if the yield curve was about to move more than others expected, you could change the convexity of the portfolio to benefit.
No.
This wouldn't necessarily help. You could suffer price declines that would otherwise be "cushioned" more without the change.
Given these strategies, when should the anticipated yield curve change take place?
No.
It does. Consider the use of those options.
Sure.
It's pretty important that it happens soon. Options expire. Plus, don't forget that these higher-convexity bonds have lower yields. You may buy a putable bond since you believe that the put value is underpriced, but putable bonds offer lower yields than similar straight bonds, exactly because that option exists.
You don't want to buy it and then just ride that lower yield to expiration. That's how you lose.
No.
If you're expecting to profit from a position, there's no benefit to waiting.
To summarize:
[[summary]]
A shift
A steepening
These must have lower yields
These must have higher yields
Add convexity to the portfolio
Reduce convexity in the portfolio
It would depend on the direction of the movement
Later
Very soon
It doesn't matter
Continue
Continue
Continue
