Rolling Down the Yield Curve
The idea that as a bond's maturity date approaches, its value will eventually converge to par
What is Rolling Down the Yield Curve?
Investors who sell bonds before they mature in order to make a larger profit are said to be rolling down the yield curve. Investors employ this fixed-income strategy when interest rates are low. The name of the strategy comes from the fact that investors sell bonds when the yield is lower.
Utilizing the yield curve, a roll-down return is a tactic for increasing a bond's total yield. It is predicated on the idea that as a bond's maturity date approaches, its value will eventually converge to par.
Long-term dated bonds provide a much larger roll-down return than short-term dated bonds. Compared to short-dated bonds, roll-down is less for long-dated bonds trading below par than short-dated bonds.
A bond investor has numerous options for figuring out a bond's return. The rate of return that will be obtained if the bond is kept until its maturity date is known as yield to maturity (YTM).
The bond's outstanding coupon payments at the moment of acquisition make up the current yield. Yet another approach to assessing a bond's profits is the roll-down return.
The yield curve, a graphical depiction of the yields for various maturities ranging from one month to 30 years, determines the roll-down return.
Selling bonds before they mature to make a larger profit is known as rolling down the yield curve. Institutional holders of municipal bonds can use expert tactics to navigate market difficulties and seize profitable opportunities through active management.
Rolling down the yield curve is one such tactic that may be challenging for individual investors to use owing to transaction expenses.
Returns may be increased by selling a bond at its highest price and rolling it into a bond with a longer maturity. This tactic works because of two ideas:
1. Bonds with longer maturities often offer higher yields to compensate for investors' uncertainty.
2. Assuming that coupon rates and duration stay constant, bonds with lower yields are more expensive.
Investors utilize this fixed-income strategy when interest rates are low. The technique's name comes from investors selling bonds when the yield is lower.
Key Takeaways
- The bond market technique known as "rolling down the yield curve" sells seasoned bonds at a premium before they mature.
- The approach is predicated on the notion that as bonds near their maturity date, their yield decreases, driving up their price.
- The approach works best when interest rates are low but rising and the yield curve is trending higher.
- The amount that interest rates can increase over a certain time before the current yield surpasses an investor's YTM is known as the roll-down return.
- The technique may be a little challenging to individual investors because of transaction costs; however, very useful for institutional investors.
How Does the Rolling Down the Yield Curve Strategy Work?
Investors can obtain a large yield by rolling down the yield curve technique, but principal losses are still kept to a minimum.
Rolling down the yield curve, or selling a bond before its maturity date after a short period, is how it is accomplished. Because of the inverse relationship between bond yield and price, the method is effective. The price rises as the yield declines.
Consider an 8-year Treasury bond that has two years remaining. Compared to five years ago, the bond's current yield is lower. This is because longer-term bonds offer greater returns due to their increased risk. As a result, the bond yield and discount rate have decreased.
This tactic may seem like the classic "free lunch" initially, but there is a reason behind it.
The bond's yield would fall over time if the investor decided to retain it until it matured. This reduced yield indicates that the bond's market risk, or price volatility, would also be lowered.
The underlying idea is that a bond's maturity determines how much its price will fluctuate due to interest rate fluctuations; the shorter the maturity, the less the shift.
The investor substitutes a lower-yielding asset with a better-yielding security by switching to a lengthier bond in any of the years well before its maturity during a low-interest environment. This higher yield makes up for the new bond's increased price volatility.
However, this deal only raises the volatility to the initial degree of risk that the investor picked. The investor increases his return by capitalizing on the market's inclination for low volatility and using the yield curve's form/ wisely when choosing maturities for selling and buying.
Note
One of the biggest myths about how the bond market operates is that increasing rates [always] results in losses
Rolling Down The Yield Curve Example
Consider the yield on a 10-year Treasury is 5.64%, and the yield on a 7-year Treasury is 3.98%. The 10-year bond will shorten to a seven-year bond after three years.
The seven-year bond can increase by 1.66% over three years before surpassing the investor's yield to maturity, which is 5.64% because the yield difference between the 10-year and 7-year is 5.64% - 3.98% = 1.66%.
This positive roll indicates that the bond's price will increase over time, supposing that interest rates stay the same. The amount that interest rates can increase over a certain time before the current yield surpasses an investor's YTM is known as the roll-down return.
In addition to the already-paid coupon payments, the investor who sells the bond will get more money than they invested. This is because the yield curve slides down as the investor makes money.
Two methods are used in roll-down returns. First, whether the bond sells at a premium or a discount to its face value determines the direction.
The roll-down impact will be advantageous if the bond sells at a discount. This indicates that the roll-down will raise the price closer to par. The converse will happen if the bond is trading at a premium. The bond's price will be reduced back to par by the negative roll-down return.
Is there a time when this strategy can't be used?
For example, the roll-down approach is ineffective if the bond trades over par or at a premium.
That would imply its price will decrease as the bond's maturity date draws closer. However, if an investor wants to use a capital loss to reduce other capital gains for tax purposes, he may follow this technique.
The approach is also less successful when the yield curve is inverted, meaning that short-term bond yields are greater than long-term bond yields. Although it occurs sporadically and for brief periods, the yield curve is historically upward-sloping.
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