Riding the Yield Curve
What Is Riding the Yield Curve?
Riding the yield curve is a trading strategy that includes buying a long-term bond and selling it before it develops in order to profit from the declining yield that happens over the life of a bond. Investors hope to accomplish capital gains by utilizing this strategy.
As a trading strategy, riding the yield curve works best in a stable interest rate environment where interest rates are not expanding. Moreover, the strategy possibly delivers excess gains when longer-term interest rates are higher than shorter-term rates.
How Riding the Yield Curve Works
The yield curve is a graphical illustration of the yields of bonds with different terms to maturities. The graph is plotted with interest rates on the y-pivot and expanding time terms on the x-hub. Since short-term bonds normally have lower yields than longer-term bonds, the curve slants upwards from the base left to the right. This term structure of interest rates is alluded to as a normal yield curve.
For instance, the rate of a one-year bond is lower than the rate of a 20-year bond in times of economic growth. At the point when the term structure uncovers a inverted yield curve, this means short-term yields are higher than longer-term yields, suggesting that investors' confidence in economic growth is low.
In bond markets, prices rise when yields fall, which will in general occur as bonds approach maturity. To exploit declining yields that happen over a bond's life, investors can carry out a fixed-income strategy known as riding the yield curve. Riding the yield curve includes buying a bond with a longer term to maturity than the investor's expected holding period to create increased returns.
Advantages of Riding the Yield Curve
An investor's expected holding period is the time span an investor plans to hold his investments in his portfolio. As per an investor's risk profile and time horizon, they might choose to hold a security short-term before selling or to hold long-term (over a year). Regularly, fixed-income investors purchase securities with a maturity equivalent to their investment horizons and hold to maturity. In any case, riding the yield curve endeavors to outperform this fundamental and low-risk strategy.
While riding the yield curve, an investor will purchase bonds with maturities longer than the investment horizon and sell them toward the finish of the investment horizon. This strategy is utilized to profit from the normal vertical slant in the yield curve brought about by liquidity inclinations and from the greater price variances that happen at longer maturities.
In a risk-neutral environment, the expected return of a 3-month bond held for a long time ought to rise to the expected return of a 6-month bond held for quite some time and afterward sold toward the finish of the three-month period. As such, a portfolio manager or investor with a three-month holding period horizon buys a six-month bond — which has a higher yield than the three-month bond — and afterward sells the bond at the three-month horizon date.
Special Considerations
Riding the yield curve is just more profitable than the classic buy-and-hold strategy on the off chance that interest rates stay something very similar and don't increase. In the event that rates rise, the return might be not exactly the yield that outcomes from riding the curve and really might fall below the return of the bond that matches the investor's investment horizon, subsequently, coming about in a capital loss.
Likewise, this strategy produces excess returns just when longer-term interest rates are higher than shorter-term rates. The more extreme the yield curve's vertical incline at the beginning, the lower the interest rates when the position is liquidated at the horizon and the higher the return from riding the curve.
Features
- For instance, an investor with a three-month investment horizon might buy a six-month bond since it has a higher yield; the investor sells the bond at the three-month date, yet profits from the higher half year yield.
- Investors then sell their bonds toward the finish of their time horizon, profiting from the declining yield that happens over the life of the bond.
- On the off chance that interest rates rise, riding the yield curve isn't quite so profitable as a buy-and-hold strategy.
- Riding the yield curve alludes to a fixed-income strategy where investors purchase long-term bonds with a maturity date longer than their investment time horizon.
