2019, Study Session # 12, Reading # 24

“YIELD CURVE STRATEGIES”

YC = yield curve

1. INTRODUCTION

Active yield curve strategies are the primary tool for

developing and implementing active fixed-income strategies.

2. FOUNDATIONAL CONCEPTS FOR ACTIVE MANAGEMENT OF YIELD CURVE STRATEGIES

2.1 2.2
A Review of Yield Duration and
Curve Dynamics Convexity

• For a zero-coupon bond:

Three basic movements in the yield curve:
there is a linear relation b/w
1) ∆ in level Macaulay duration and
2) ∆in slope maturity.
3) ∆in curvature
Convexity ≈[duration]2.

• If spread widens(narrows), the yield curve becomes • Coupon-paying bonds have higher
steepen (flatten) convexity as compared to zero-
• Negative value of spread results in inverted yield curve. coupon bonds
• Common measure of the yield curve curvature is the • Convexity (+ve or -ve) is an important
butterfly spread. factor in a bond portfolio’s return.
Butterfly Spread = -(Short-term yield) + (2 x Medium-term
yield) – Long-term yield
• These three changes in the yield curve are interrelated.
Generally, for a(an):

↑ shift in level, the yield curve flattens and
becomes less curved.

↓ shift in level, the yield curve steepens and
becomes more curved.

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 2019, Study Session # 12, Reading # 24

3. MAJOR TYPES OF YIELD CURVE STRATEGIES

Active strategies have been categorized into the following two groups.
1. Active strategies under assumption of a stable yield curve
1) Buy & hold 2) Roll Down/Ride the Yield Curve 3) Sell Convexity 4) The Carry Trade
2. Active strategies for yield curve movement of level, slope, and curvature
1) Duration Management 2) Buy Convexity 3) Bullet & Barbell Structures

3.1
Strategies under Assumptions of 3.2
a Stable Yield Curve Strategies for Changes in Market
Level, Slope, or Curvature

3.1.1 3.1.2 3.1.3 3.1.4

Buy & Hold Riding the Yield Curve Sell Convexity Carry Trade

• constructing a • An aggressive In anticipation of lower • Manager purchases ↑ yield security, which is

portfolio whose version of buy & future volatility or financed at a rate ↓ and earns the spread between
features deviate hold strategy.
stable yield curve, the two rates. This strategy frequently involves ↑
from the • The strategy leverage& position a portfolio in anticipation of
benchmark, & the portfolio returns can be
works if the YC is stable yield curve.
portfolio is held ↑ sloping & is enhanced by
• Cross-currency carry trade implies borrowing in a
constant for certain likely to remain reducing/selling the
currency of a ↓ i-rate country and investing
time period. static. portfolio convexity i.e. proceeds in a currency of a ↑ i- rate country.
• This is not a passive • This strategy is receiving option Three common ways to implement inter-market
strategy as it may based on the premiums by selling the carry trade are:
appear due to low concept of “roll calls and puts on the 1) Borrow in the lower rate currency and invest
portfolio turnover. down”.
bonds. higher rate currency.
2) Enter into a currency swap
3) Borrow and invest in higher rate currency, and
then convert the financing position to the lower
rate currency through FX forward market.

3.2.1 3.2.2 3.2.3

Duration Management Buy Convexity Bullet & Barbell Structures

Managers ↓ (↑) portfolio duration

in anticipation of ↑ (↓) i-rates.

3.2.1.1
Using Derivatives to Alter Portfolio Duration
• An active portfolio manager can shift the
portfolio to be more laddered (securities
Portfolio duration can be altered using futures • is valuable when i-rates are distributed equally around various maturities),
contract, leverage and interest rate swaps. expected to be volatile. bullet (securities concentrated around single
• Futures contracts are sensitive to changes in • helps managers earning point on YC) or barbell (securities
the price of the underlying bonds and no additional return, without concentrated at longer and shorter points).
cash outlay is required except posting and altering the portfolio • Bullet and barbell structures are the most
maintaining margin. duration. common approaches to benefit from non-
• To increase the portfolio duration, add • using options to enhance parallel shifts in the YC.
desired PVBP by purchasing bonds of any portfolio convexity is an • A bulleted portfolio will have little exposure
duration through leverage. alternative for managers away from the target segment of the curve.
• Interest rate swaps can be created for every who find it difficult to ∆ the • A barbell portfolio exhibits higher convexity
maturity; however, they are less liquid than portfolio structure easily. than a bullet portfolio.
futures and less flexible than using leverage.
• Bullet (Barbell) structure is usually used to
To lengthen(shorten) duration add a
take advantage of a steepening (flattening) YC.
receive-fixed (pay-fixed) swap.

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 2019, Study Session # 12, Reading # 24

4. FORMULATING A PORTFOLIO
POSITIONING STRATEGY GIVEN
A MARKET VIEW

4.1 4.2 4.3 4.4

Duration Portfolio Positioning in Performance of Duration- Using Options
Positioning in Anticipation of a Change Neutral Bullets, Barbells,
Anticipation of a in Interest Rates, and Butterflies Given a
Parallel Upward Direction Uncertain Change in the Yield Curve
Shift in the Yield
Curve
• Adding convexity using options
can be performed by selling
some bonds and purchasing call
Manager can improve the options on those bonds in a way
portfolio returns under such that the portfolio’s effective
scenario by ↑ the portfolio duration and market value
convexity. i.e. if rates ↑ the remains unchanged.
portfolio will bear ↓ losses • Par value of the options = Par
and if rates ↓, the gains will value of the bonds sold

ᇲ   
be ↑. ×

ᇲ   
• The post trade portfolio
outperforms the pre-trade
portfolio when interest rate
change as long as the rate
change is greater than certain
basis points.
4.3.1 4.3.2
Bullets and Barbells Butterflies

4.4.1
Changing Convexity
Consider two duration-matched • a long-short combination of bullet and Using Securities with
portfolios of equal market value, a barbell portfolio structures. embedded Options
barbell portfolio containing 5-year bonds • The butterfly structure is created by
and a bullet portfolio containing two taking position in three securities; short-
bonds of zero maturity and 10-year term, intermediate term and long-term.
maturity respectively. • Two types of butterfly structures include:

Long barbell, short bullet – ↑ • Convexity can be ↓ by selling

If there is an instant ↓ parallel shift in convexity position, benefit from a
options or buying MBS.
the YC, barbell portfolio will flattening of the YC.
Buying MBS is equivalent to
outperform bullet portfolio.
Long bullet, short barbell – ↓
selling call options as MBS

If the YC flattens in a way that short- convexity position, beneficial amid exhibits -ve convexity.
term rates ↑ and long-term rates stable interest rate prediction or
• If the YC is expected to
o remain unchanged, the barbell steepening of the YC.
remain stable sell the
portfolio will outperform the • Some common ways to select the
bullet portfolio. treasury bonds and purchase
weights of the butterfly wings are: MBS.
o ↓, the barbell portfolio will
Duration neutral
outperform the bullet portfolio. • Compared to treasury bonds,

50/50

If the YC steepens, the bullet portfolio MBS are more sensitive to ↑

Regression weighting
will outperform the barbell portfolio. in rates and less sensitive to ↓
in rates.

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 2019, Study Session # 12, Reading # 24

5. INTER-MARKET CURVE STRATEGIES

Primary driver of inter-market trades is:

Future outlook of narrowing or widening of yield spreads between
markets including differential changes in the slopes or shapes of
curves.

Two related issues include:

• Capital mobility situation between the markets
• Stability of exchange rate between currencies

Currency-hedged foreign bonds and domestic bonds are not perfect

substitutes unless covered in forward market.

6. COMPARING THE PERFORMANCE OF VARIOUS DURATION-NEUTRAL

PORTFOLIOS IN MULTIPLE CURVE ENVIRONMENTS

7. A FRAMEWORK FOR
EVALUATING YIELD CURVE TRADES

Expected return can be decomposed into five sub-components.

This decomposition can help understanding the relative
contribution of each component in the performance of the
strategy.

E(R)  Yield income + Rolldown return + E(∆ in price based on

investor’s views on yields and yield spread)  E(Credit losses) +
E(currency gains & losses)

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