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Level III Yield Curve Strategies Summary Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Major Types of Yield Curve Strategies (1/2) Active strategies under assumption of a stable yield curve Buy and hold Build portfolio with characteristics different from benchmark; minimize trading over investment horizon Roll down (ride) yield curve Works with upward sloping yield curve As bond ages  yield down  price up Target steep portion of yield curve  significant price appreciation Sell convexity If yields are stable then convexity does not help  sell convexity Sell options or buy callable bonds and MBS Carry trade Buy securities with high yield and finance with low-yield securities www.ift.world Major Types of Yield Curve Strategies (2/2) Active strategies for yield curve movement of level, slope, and curvature Duration management % P change ≈ D ì Y (in percentage points) Duration management methods: Number of futures contracts = Required additional PVBP / PVBP of the futures contract • MV of purchased bonds = (Additional PVBP / Duration of bonds to be purchased ) x 10,000 • Effective portfolio duration ≈ (Notional portfolio value / portfolio equity ) x duration • Notional value of swaps = Additional PVBP / PVBP of swap How the duration is changed does matter Bullet and barbell structures Bullets target a single segment of the yield curve; barbells target short and long yields Bullet structures well when yield curve steepens Barbell structures well when yield curve flattens Buy convexity If yield is expected to change  add convexity Higher convexity bonds are more expensive (lower yield) Convexity can be bought by 1) altering portfolio structure or 2) buying call options www.ift.world Altering Portfolio Convexity Adding Convexity Reducing Convexity Make structure more barbelled Make structure more bulleted Buy options Sell options Buy callable bonds Buy mortgage backed securities www.ift.world Portfolio Positioning Strategy Given Forward Rates and Interest Rate View View Strategy Upward sloping yield curve which will remain stable Roll down the yield curve Parallel shift up Lower duration Parallel shift down Higher duration High interest rate volatility Add convexity • Buy options • More barbelled structure If yield change does not materialize the higher convexity will cause a yield drag Low interest rate volatility Sell convexity • Sell options • More bulleted structure Flatter yield curve Barbell Steeper yield curve Bullet www.ift.world Use of Derivatives to Implement Yield Curve Strategies Altering Duration • Number of futures contracts = Required additional PVBP / PVBP of the futures contract • Notional value of swaps = Additional PVBP / PVBP of swap Altering Convexity To add convexity of portfolio: • Sell bonds and buy options  Par value of options needed = Par value of bonds being sold x (bond’s PVBP / option’s PVBP) To reduced convexity of portfolio: • Sell options • Replace regular bonds with callable bonds or MBS www.ift.world Evaluating Sensitivity to Changes in Slope using KRDs Key rate durations (KRD, partial durations) measure duration at key points on the yield curve • Used to identify bullets and barbells • Sum of KRDs ≈ effective duration Predicted change = Portfolio par amount × Partial PVBP × (–Curve shift) www.ift.world Constructing Duration Neutral Portfolios to Benefit from Change in Curvature Butterfly Structures Long barbell and a short bullet  Benefit from flattening yield curve  Benefit from increase in curvature  More valuable when interest rate volatility is high Short barbell and a long bullet  Benefit from steepening yield curve  Benefit from decrease in curvature  More valuable when interest rates are stable Condor: positions Examples: Long 2s Short 5s and Short 10s Long 30s Short 2s Long 5s and Long 10s Short 30s www.ift.world Framework for Evaluating Yield Curve Trades E(R) ≈ Yield income + Rolldown return + E(Change in price based on investor’s views of yields and spreads) - E(Credit losses) + E(Currency gains or losses) If forecasted ending yield < forward rate  expected return > one-period rate If forecasted ending yield > forward rate  expected return < one-period rate Expected gain/loss from change in yield [-MD ì Yield] + [ẵ ì Convexity ì (∆Yield)2] www.ift.world ... securities with high yield and finance with low -yield securities www.ift.world Major Types of Yield Curve Strategies (2/2) Active strategies for yield curve movement of level, slope, and curvature... down (ride) yield curve Works with upward sloping yield curve As bond ages  yield down  price up Target steep portion of yield curve  significant price appreciation Sell convexity If yields are... segment of the yield curve; barbells target short and long yields Bullet structures well when yield curve steepens Barbell structures well when yield curve flattens Buy convexity If yield is expected