Negative Butterfly
What Is a Negative Butterfly?
A negative butterfly is a non-parallel shift in the yield curve where long and short-term yields fall more or rise not exactly intermediate rates.
A negative butterfly shift successfully humps the plot of the yield curve. Something contrary to a negative butterfly, where long and short-term yields rise more or fall not exactly intermediate rates, is called a positive butterfly.
Understanding a Negative Butterfly
Yield curves are graphic presentations of the interest rates of comparable quality bonds relative to their maturity dates. Yield curves don't endeavor to foresee the future of bond rates, but the relative position of current rates can assist investors with coming to conclusions about which bonds are probably going to pay off best from here on out. They are used to illustrate investor sentiments about the value of various bond maturities.
The most common yield curve plots the yields of U.S. Treasuries (short-, medium-, and long-term bonds). Usually, the Treasury yield curve presents a rising arc from left to right, with short-term bonds on the left yielding not exactly medium-term bonds in the center and long-term bonds on the right. This is because investors generally expect a higher yield as they are lending their money for additional extended periods of time.
The purposes behind yield curve shifts are muddled and rely upon investor sentiment, economic news, and Federal Reserve policy, among different factors. Nonetheless, bond yields don't necessarily follow standard rules. For instance, short-and long-term rates could diminish by 75 basis points (0.75), while intermediate rates just reduction by 50 basis points, (0.50). The resulting hump in the center of the graph is a negative butterfly shift. The reverse is a positive butterfly (where the graph looks U-shaped).
From a bond trading point of view, why it happens is less important than what to do about it. Most importantly, butterfly shifts present traders with arbitrage opportunities, since the rate variances can be showcased to augment short-term profit. A common bond trading refrain when the yield curve turns into a negative butterfly is to sell the belly and purchase the wings, and that means to sell the higher-rate intermediate bonds — or the belly of the butterfly — and acquire the short-and long-term bonds (which are the outside low-balancing wings of the butterfly in the graphic model). Along these lines, traders endeavor to even out their exposure to bond maturities that are shifting out of parallel. In reality, bond traders will factor in numerous factors when strategizing buy and sell orders, including the average maturity date of bonds in their portfolio — although the state of the yield curve is an important indicator.
Negative Butterfly versus Positive Butterfly
A negative butterfly occurs when short-term interest rates and long-term interest rates decline by a greater degree than intermediate-term interest rates, accentuating the hump in the curve.
Then again, a positive butterfly occurs when short-term interest rates and long-term interest rates increase at a higher rate than intermediate-term rates. This makes a non-parallel shift in the curve, making the curve less humped (or less curved).
For instance, assume the yields on 1-year Treasury bills and 30-year Treasury bonds move upward by 50 basis points (0.50%). Further, suppose the rate of 10-year Treasury notes continue as before; the convexity of the yield curve would increase, making a positive butterfly.
Features
- Traders sell the belly (higher-yielding intermediate bonds) and purchase the wings (lower-yielding short-and long-term bonds) when confronted with a negative butterfly.
- A negative butterfly is a non-parallel shift in the yield curve where long and short-term yields fall more or rise not exactly intermediate rates.
- A negative butterfly shift successfully humps the yield curve — the center is called the "belly" and the finishes are called the "wings."
