2018, Study Session # 10, Reading # 23 “YIELD CURVE STRATEGIES” YC = yield curve INTRODUCTION Active yield curve strategies are the primary tool for developing and implementing active fixed-income strategies FOUNDATIONAL CONCEPTS FOR ACTIVE MANAGEMENT OF YIELD CURVE STRATEGIES 2.2 Duration and Convexity 2.1 A Review of Yield Curve Dynamics Three basic movements in the yield curve: 1) ∆ in level 2) ∆in slope 3) ∆in curvature • If spread widens(narrows), the yield curve becomes steepen (flatten) • Negative value of spread results in inverted yield curve • Common measure of the yield curve curvature is the butterfly spread 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 • For a zero-coupon bond: there is a linear relation b/w Macaulay duration and maturity Convexity ≈[duration]2 • Coupon-paying bonds have higher convexity as compared to zerocoupon bonds • Convexity (+ve or -ve) is an important factor in a bond portfolio’s return Copyright © FinQuiz.com All rights reserved 2018, Study Session # 10, Reading # 23 MAJOR TYPES OF YIELD CURVE STRATEGIES Active strategies have been categorized into the following two groups 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 Active strategies for yield curve movement of level, slope, and curvature 1) Duration Management 2) Buy Convexity 3) Bullet & Barbell Structures 3.2 Strategies for Changes in Market Level, Slope, or Curvature 3.1 Strategies under Assumptions of a Stable Yield Curve 3.1.1 Buy & Hold • constructing a portfolio whose features deviate from the benchmark, & the portfolio is held constant for certain time period • This is not a passive strategy as it may appear due to low portfolio turnover 3.1.2 Riding the Yield Curve • An aggressive version of buy & hold strategy • The strategy works if the YC is ↑ sloping & is likely to remain static • This strategy is based on the concept of “roll down” 3.1.3 Sell Convexity In anticipation of lower future volatility or stable yield curve, portfolio returns can be enhanced by reducing/selling the portfolio convexity i.e receiving option premiums by selling the calls and puts on the bonds 3.1.4 Carry Trade • Another strategy to position a portfolio in anticipation of stable yield curve • In a carry trade, manager purchases ↑ yield security, which is financed at a rate ↓ than the yield on that security, and earns the spread between the two rates This strategy frequently involves ↑ leverage • Cross-currency carry trade implies borrowing in a currency of a ↓ i-rate country and investing proceeds in a currency of a ↑ i- rate country 3.2.2 Buy Convexity 3.2.1 Duration Management 3.2.3 Bullet & Barbell Structures Managers ↓ (↑) portfolio duration in anticipation of ↑ (↓) i-rates 3.2.1.1 Using Derivatives to Alter Portfolio Duration Portfolio duration can be altered using futures contract, leverage and interest rate swaps • Futures contracts are sensitive to changes in the price of the underlying bonds and no cash outlay is required except posting and maintaining margin • To increase the portfolio duration, add desired PVBP by purchasing bonds of any duration through leverage • Interest rate swaps can be created for every maturity; however, they are less liquid than futures and less flexible than using leverage To lengthen(shorten) duration add a receive-fixed (pay-fixed) swap • is valuable when i-rates are expected to be volatile • helps managers earning additional return, without altering the portfolio duration • using options to enhance portfolio convexity is an alternative for managers who find it difficult to ∆ the portfolio structure easily • An active portfolio manager can shift the portfolio to be more laddered (securities distributed equally around various maturities), bullet (securities concentrated around single point on YC) or barbell (securities concentrated at longer and shorter points) • Bullet and barbell structures are the most common approaches to benefit from nonparallel shifts in the YC • A bulleted portfolio will have little exposure away from the target segment of the curve • A barbell portfolio exhibits higher convexity than a bullet portfolio • Bullet (Barbell) structure is usually used to take advantage of a steepening (flattening) YC Copyright © FinQuiz.com All rights reserved 2018, Study Session # 10, Reading # 23 FORMULATING A PORTFOLIO POSITIONING STRATEGY GIVEN A MARKET VIEW 4.1 Duration Positioning in Anticipation of a Parallel Upward Shift in the Yield Curve 4.2 Portfolio Positioning in Anticipation of a Change in Interest Rates, Direction Uncertain 4.4 Using Options 4.3 Performance of DurationNeutral Bullets, Barbells, and Butterflies Given a Change in the Yield Curve • Adding convexity using options can be performed by selling some bonds and purchasing call options on those bonds in a way that the portfolio’s effective duration and market value remains unchanged • Par value of the options = Par value of the bonds sold Manager can improve the portfolio returns under such scenario by ↑ the portfolio convexity i.e if rates ↑ the portfolio will bear ↓ losses and if rates ↓, the gains will be ì ã 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 Bullets and Barbells Consider two duration-matched portfolios of equal market value, a barbell portfolio containing 5-year bonds and a bullet portfolio containing two bonds of zero maturity and 10-year maturity respectively If there is an instant ↓ parallel shift in the YC, barbell portfolio will outperform bullet portfolio If the YC flattens in a way that shortterm rates ↑ and long-term rates o remain unchanged, the barbell portfolio will outperform the bullet portfolio o ↓, the barbell portfolio will outperform the bullet portfolio If the YC steepens, the bullet portfolio will outperform the barbell portfolio 4.3.2 Butterflies • a long-short combination of bullet and barbell portfolio structures • The butterfly structure is created by taking position in three securities; shortterm, intermediate term and long-term • Two types of butterfly structures include: Long barbell, short bullet – ↑ convexity position, benefit from a flattening of the YC Long bullet, short barbell – ↓ convexity position, beneficial amid stable interest rate prediction or steepening of the YC • Some common ways to select the weights of the butterfly wings are: Duration neutral 50/50 Regression weighting Copyright © FinQuiz.com All rights reserved 4.4.1 Changing Convexity Using Securities with embedded Options • Convexity can be ↓ by selling options or buying MBS Buying MBS is equivalent to selling call options as MBS exhibits -ve convexity • If the YC is expected to remain stable sell the treasury bonds and purchase MBS • Compared to treasury bonds, MBS are more sensitive to ↑ in rates and less sensitive to ↓ in rates 2018, Study Session # 10, Reading # 23 COMPARING THE PERFORMANCE OF VARIOUS DURATION-NEUTRAL PORTFOLIOS IN MULTIPLE CURVE ENVIRONMENTS Relative performance of Bullet and Barbell under different yield curve scenarios Yield Curve Scenarios Level ∆ Parallel Shift Outperforms Barbell Slope ∆ Flattening Steepening Less More Decreased Increased Barbell Bullet Bullet Barbell Bullet Barbell Curvature ∆ Rate Volatility ∆ Underperforms Bullet Bullet Barbell Barbell Bullet Barbell Bullet 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) Copyright © FinQuiz.com All rights reserved ... bonds and purchase MBS • Compared to treasury bonds, MBS are more sensitive to ↑ in rates and less sensitive to ↓ in rates 2018, Study Session # 10, Reading # 23 COMPARING THE PERFORMANCE OF VARIOUS... a currency of a ↑ i- rate country 3. 2.2 Buy Convexity 3. 2.1 Duration Management 3. 2 .3 Bullet & Barbell Structures Managers ↓ (↑) portfolio duration in anticipation of ↑ (↓) i-rates 3. 2.1.1 Using... Copyright © FinQuiz. com All rights reserved 2018, Study Session # 10, Reading # 23 FORMULATING A PORTFOLIO POSITIONING STRATEGY GIVEN A MARKET VIEW 4.1 Duration Positioning in Anticipation of a Parallel