What it means
The yield curve is a line showing the interest rates (yields) on bonds of different lengths. In normal conditions it slopes upwards, so a three-year bond yields more than a one-year bond.
Riding the yield curve takes advantage of that slope. Here is how it works: an investor with a one-year horizon buys a three-year bond rather than a one-year bond.
After a year, the bond has two years left, so it is priced using the two-year yield, which is lower than the three-year yield. A lower yield means a higher price, and the investor sells at a gain.
This extra gain is often called roll-down return. It is on top of the interest the bond pays while the investor holds it.
If the curve stays the same shape, the strategy beats simply buying a bond that matures at the end of the holding period. The strategy has risks.
If interest rates rise during the holding period, the bond's price falls, and the gain from rolling down can be wiped out or turned into a loss. The longer the bond, the more sensitive its price is to changes in rates, so the investor takes on more risk than a short-term holder.
It also depends on the curve shape. When the curve is flat or inverted, with short-term rates equal to or above long-term rates, the roll-down gain disappears or turns negative.
Investors therefore judge the slope of the curve before using the approach. Corporate treasurers, bond fund managers and individual investors can all use the strategy.
The key is to compare the expected return with the safer alternative, and to allow for trading costs and taxes, which can reduce the benefit.
In practice
Real-world examples.
Example
A corporate treasurer has cash needed in twelve months. Instead of a one-year bill, she buys a three-year bond and plans to sell after one year, hoping to gain from the curve's slope. She checks that she can sell the bond easily if the cash is needed earlier.
Example
A bond fund manager holds a portfolio of five-year bonds and sells them as they approach three years. He aims to capture the price gains as the bonds roll down a steep curve. He reviews the strategy each month against the slope of the curve.
Example
An investor notices that the yield curve has flattened. He decides riding the curve no longer offers enough extra return to justify the interest rate risk, and he buys shorter bonds instead. He will revisit the idea if the curve steepens again.
Formula
Calculation
Price of a zero-coupon bond = Face value / (1 + Yield) ^ Years to maturity
Holding-period return = (Selling price / Purchase price) - 1
Suppose an investor has a one-year horizon and a face value of $1,000,000. The three-year yield is 5%, the two-year yield is 4.5%, and the one-year yield is 4%. Assume the curve stays unchanged.
Purchase price of the three-year bond: $1,000,000 / 1.05^3 = $863,838
Selling price after one year (now a two-year bond): $1,000,000 / 1.045^2 = $915,730
Holding-period return: $915,730 / $863,838 - 1 = 6.0%
Compare this with buying a one-year bond at 4%, which returns 4.0%. Riding the curve earns roughly 2 percentage points more, but only if yields do not rise.Case study
Seen in the real world.
Falcon Treasury Partners is a fictional investment firm used in an illustrative scenario. A client has $10,000,000 to invest for one year and asks about alternatives to one-year bills.
The firm shows that three-year bonds yield 5% and two-year bonds yield 4.5%. If the curve is unchanged, the bond bought today will be worth about 6.0% more after a year, compared with 4.0% for a one-year bill. The expected gain is about $200,000 more on $10,000,000.
The client accepts the strategy but sets a limit. If yields rise by one percentage point, the price loss on the bond could outweigh the gain, so the firm monitors rates and agrees to sell early if the loss reaches an agreed threshold. It also explains the dealing costs so the client sees the net gain.
Watch out
Common mistakes.
- Assuming the strategy is risk free. A rise in yields can cause a loss that wipes out the roll-down gain.
- Using it when the curve is flat or inverted. The extra return depends on a rising slope.
- Ignoring costs and taxes. Dealing spreads and tax on gains can eat into the benefit, so always compare the return after costs.
Questions
People also ask.
What is roll-down return?
It is the price gain a bond earns as it moves to a shorter maturity with a lower yield, if the curve stays the same. It is added to the interest income earned while holding the bond.
Does the strategy work for any bond?
It works best for high quality bonds in a market where yields are well defined across maturities.
How is it different from just buying long bonds?
The investor intends to sell before maturity, and the focus is on the holding-period return rather than the final payout.
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