What is Rolling Down the Yield Curve?
Rolling down the yield curve is when investors sell bonds before maturity date to get a higher profit. This is a fixed income strategy that investors use in a low rate environment. The strategy gets its name as investors are selling bonds when the yield is lower.
Quick Summary Points
- Rolling down the yield curve is a fixed income strategy where the bond is sold before maturity
- This strategy provides investors with a higher incremental income without increasing exposure to interest rate risk
- Rolling down the yield curve is not suitable when the yield curve is inverted or if the bond is sold at a premium
How does the strategy work?
This strategy strives to help investors obtain a high yield while still limiting loss on the principle. This is achieved by rolling down the yield curve, or in other words, selling a bond after holding it for a few years. The strategy work as the yield and price of bonds move in opposite directions. As the yield decrease, the price increase.
Imagine a 10-year treasury bond with five years left to maturity. The yield of the bond now is lower compared to the yield five years before. This is because higher yields are given to longer-term bonds due to higher risk. The bond now has a lower yield and lower discount rate. Due to the nature of bonds, the price of the bond is now higher than it was before. This strategy also limits the loss on the principle because investors are selling the bond early so have less exposure to credit or interest rate risk.
What are the benefits of rolling down the yield curve?
By buying a longer-term bond, investors get higher yields on their investment. This means higher income from coupons or when the bond is sold. Another benefit is that rolling down the yield curve provides more options for investors. For example, if an investor wants to invest their money for five years, they can either buy a five-year bond or buy a longer term bond and sell it after five years. By buying the longer term bond, they would benefit from the higher incremental income. Also, they would gain from the sale of the bond while still keeping the investment horizon to five years.
When is the best time for this strategy?
Rolling down the yield curve is most suitable in a low-interest rate environment but with the rate rising or expected to rise. As the interest rate rises, bonds lose value. This is interest rate risk and it impacts bonds with a long maturity. If interest rates are expected to increase, then investors will tend to stick with short term bonds as those are less susceptible to interest rate risk. However, by doing this, they are limiting their return to lower yields. This is when rolling down the yield curve becomes profitable. Investors can buy long term bonds and benefit from the higher yield. Also, since they plan to sell before maturity, their interest rate risk is not as high.
When to not use this strategy?
Rolling down the yield curve is not suitable if the yield curve is inverted or if the bond is a premium bond. An inverted yield curve is where the yields of a shorter duration bond are higher than that of a higher duration bond. Thus, an investor that wants to invest for only five years has no incentive to purchase a 10-year bond as they will not receive higher yields. Another reason to not use the strategy is if the bond is selling at a premium. A premium bond’s value decrease as time goes on. Thus, an investor will not be able to roll down the yield curve and sell the bond for more than they paid for.
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