Rolling Down the Curve – A Strategy for a Steep Yield Curve
Currently, the Treasury yield curve is exceptionally steep and normal shaped (i.e., shape of the yield curve when short rates are lower than long rates), while short-term and money-market funds are simultaneously yielding historic lows near zero percent. When the yield curve is steep it means that market participants expect rates to be higher in the future than they are today. The combination of these factors creates a yield curve which provides investors with an opportunity to “roll down the curve”. As a bond approaches maturity it will gradually “roll down the curve” toward lower yields each year as it moves closer to maturity. As this occurs the bond will be valued at successively lower yields and thus potentially higher prices as it gradually moves down the yield curve. This strategy may help protect principal in a rising interest rate environment and allow an investor to capture higher yields. This strategy works best when the yield curve remains upward sloping and when rates rise less than the markets are predicting. Conversely, if yields rise by the full amount that the markets predict, the benefits of this strategy could be zero.
Current Intermediate Rates Provide an Excellent Backdrop
The chart below illustrates how the 2yr-5yr spread has fluctuated over the last 24 months, and is down from +162 basis points (or 1.62%) in January 2010, currently sitting well below its two-year average of +114bp (as of 1/4/2012). Conversely, the 5yr-10-yr spread remains steeper than its counterpart, and remains at an elevated level near its average of +126bp. In other words, the front-end of the yield curve has recently flattened, while the intermediate portion remains steep. Given that the difference (spread) between the 10-year and 5-year Treasuries has been increasing (steepening), this provides an excellent opportunity to “roll down the curve.”
The chart below examines the opportunity in the 5-year to 7-year maturities for this strategy as indicated by a 6-month roll-down return. The bars on the right-hand scale indicate the roll-return for a given maturity over a 6-month holding period assuming that the yield-curve remains the same. Under this scenario, a 7-year Treasury held for 6-months would appreciate in price by nearly 83bp as the bond “rolls down the curve” towards a lower portion of the yield-curve. In essence, a bond will appreciate in value as yields decline due to the passage of time, thereby providing a cushion in the form of a higher total return.
Similar to the Treasury yield curve, typical corporate yield curves remain normal in shape and the spreads between the two provide a similar roll-down opportunity to that of Treasuries. Notice again that the 7-year maturity provides a significant premium to that of the preceding 5-year maturity and a similar pattern is evident from the 10-year maturity as it rolls toward a 9-year. This trend is also apparent in the 5-year space by the effects are muted as the years to maturity shorten.
How to Implement this Strategy
When selecting bonds to utilize a “rolling down the curve” strategy attempt to locate bonds in the steepest areas of the yield curve. Currently, the Treasury yield curve provides opportunities at the 7-year maturity as it moves toward a 5-year and the 10-year maturity as it moves down towards a 9-year. As indicated by the Bloomberg corporate ‘A’ Index in the chart above, corporate bonds provide a more broad set of maturity opportunities as the 4 to 10-year sections of the yield curve provide strong roll-down potential. There are risks involved with this strategy including, but not limited to, changes in interest rates, liquidity, credit quality, volatility and duration. Past performance is no assurance of future results. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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