Positive Butterfly

What Is a Positive Butterfly?

A positive butterfly is a non-parallel yield curve shift that happens when short-and long-term interest rates shift up by a greater magnitude than medium-term rates. This shift effectively diminishes the overall curvature of the yield curve.

A positive butterfly might be contrasted with a negative butterfly, and ought not be confounded by the options strategy known as a long butterfly.

Understanding Positive Butterflies

The yield curve is a visual representation that plots the yields of comparative quality bonds against their maturities, going from shortest to longest. The yield curve shows the yields of bonds with maturities going from 90 days to 30 years and, thus, empowers investors at a quick look to compare the yields offered by short-term, medium-term, and long-term bonds.

The short finish of the yield curve in view of short-term interest rates is determined by expectations for the Federal Reserve (Fed) approach; it rises when the Fed is expected to raise rates and falls when interest rates are expected to be cut. The long finish of the yield curve, then again, is impacted by factors, for example, the outlook on inflation, investor demand and supply, economic growth, institutional investors trading large blocks of fixed-income securities, etc.

In a normal interest rate environment, the curve slants up from left to right, indicating a normal yield curve. Nonetheless, the yield curve changes while winning interest rates in the markets change. At the point when the yields on bonds change by similar magnitude across maturities, we call the change a parallel shift. Alternatively, when the yields change in different magnitudes across maturities, the resulting change in the curve is a non-parallel shift.

A non-parallel change in interest rates might lead to a negative or positive butterfly, which are terms used to portray the state of the curve after it shifts. The connotation of a butterfly is given in light of the fact that the intermediate maturity sector is compared to the body of the butterfly and the short maturity and long maturity sectors are seen as the wings of the butterfly.

Positive versus Negative Butterflies

The negative butterfly happens when short-term and long-term interest rates decline by a greater degree than intermediate-term rates, accentuating the protuberance in the curve. On the other hand, a positive butterfly happens when short-term and long-term interest rates increase at a higher rate than intermediate-term rates.

Put another way, medium-term rates increase at a lesser rate than short-and long-term rates, causing a non-parallel shift in the curve that makes the curve less bumped — that is, less curved. For instance, expect the yields on one-year Treasury bills (T-bills) and 30-year Treasury bonds (T-bonds) move up by 100 basis points (1%). If during a similar period, the rate of 10-year Treasury notes (T-notes) continues as before, the convexity of the yield curve will increase.

Buying the Belly of the Butterfly

A common bond trading strategy when the yield curve goes through a positive butterfly is to buy the "belly" and sell the "wings". This just means that bond traders will sell the short-and long-term bonds (the wings) of the yield curve and buy the intermediate bonds (the belly) simultaneously. The traders expect the middle portion of the curve to rise faster in light of the fact that intermediate-term rates increase relatively faster than rates on the other two gatherings of bonds.

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. But, the state of the yield curve is nonetheless an important indicator.

Highlights

• A common bond trading strategy when the yield curve presents a positive butterfly is to buy the "belly" and sell the "wings".
• A positive butterfly happens when there is a non-equivalent shift in a yield curve brought about by long-and short-term yields rising by a higher degree than medium-term yields.
• A butterfly suggests a "twisting" of the yield curve, creating less curvature.