Yield Curve strategies are more sophisticated interest rate anticipation
strategies take into account the differences in interest rates for different
terms of bonds, the "term structure" of interest rates.
As we know, interest rates change. The change, however, is not
consistent across terms depending on market and economic conditions. For
example, in September 1996, short-term interest rates (Treasury Bills) in Canada
were just over 4% and long-term interest rates (30 year bonds) were nearly 8%. A
chart of the interest rates for bonds of different terms is called the "yield
curve". A yield curve strategy would position a bond portfolio to profit
the most from an expected change in the yield curve, based on an economic or
market forecast.
If interest rates change by the same amount for all terms of bonds, the
yield curve is said to have had a "parallel shift". This almost never
happens. When the difference between short- and long-term interest rates
increases, the yield curve is said to "steepen"; when the difference
between short- and long-term rates decreases, the yield curve is said to "flatten".
An investor expecting a monetary policy tightening and short rates to increase
more than long rates might adopt a "barbell" portfolio, with very
short and very long bonds. This would be based on the premise that the combined
performance of this "barbell" portfolio would be better than a "bullet"
portfolio entirely of mid-term bonds. Yield curve stategists refer portfolio
positioning as "butterfly" trades with the "wings" of a
trade being the short and long components on the yield curve and the "body"
as the middle portion of the trade. Yield curve strategies can span the whole "yield
curve" or be limited to a certain term area such as mid-term bonds.
The stock in trade of the yield curve strategist is bond mathematics.
Duration is used as a measure of a portfolio's sensitivity to a change in
interest rates. Convexity is used as a measure of how duration and price
sensitivity changes over a range of interest rate scenarios. Managers are said
to be "buying convexity" when they shift into higher convexity bonds
and possibly reducing their portfolio yield. |
