Yield Curve Strategies

Most of an active bond manager's decisions are bets on the yield curve: its level, its slope, its shape and its volatility. This module shows how to measure those exposures with key rate durations, how to profit from a static or a changing curve relative to the forward curve, how to position for volatility through convexity and options, and how to estimate the expected return of a position, including across currencies.

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What you will learn

1. Decompose portfolio returns arising from changes in the level, slope and curvature of the benchmark yield curve, and contrast bullets, barbells and duration-neutral curve trades.

Level (parallel shift), slope (long minus short yield) and curvature (middle versus wings) explain most curve moves.
Bull and bear describe falling and rising yields; steepening and flattening describe the slope.
Duration-matched bullets win when the curve steepens around their maturity; barbells win when it flattens or the middle cheapens.
Steepener: buy short, sell long in equal BPVs; flattener: the reverse; butterflies isolate curvature.
Duration-neutral means equal BPVs, not equal face amounts.

2. Formulate yield curve strategies when the manager's rate view matches, or differs from, the forward curve, including buy-and-hold, rolldown, carry trades and duration changes.

If rates follow the forward curve, all maturities earn about the short rate: active positioning adds value only when the view differs from forwards.
Stable-curve view on an upward-sloping curve: buy and hold longer bonds, ride the curve, run carry trades.
Rolling yield = yield income + rolldown return.
Expect bigger falls than forwards: extend duration or receive fixed; bigger rises: shorten or pay fixed.
Carry and rolldown resemble short-option payoffs: small steady gains, large losses in sharp sell-offs.

3. Position a fixed-income portfolio for expected changes in interest rate volatility using convexity, options and bonds with embedded options.

Convexity gains are proportional to the squared yield change, so they grow with volatility in either direction.
Higher expected volatility: barbells, long options, putable bonds; avoid callables and MBS (negative convexity).
Lower expected volatility: bullets, short options, callable bonds and MBS for their extra yield.
Convexity costs yield; breakeven move: 0.5 x (C1 - C2) x (change in yield) squared = yield give-up.
A volatility view is a view on realized versus implied volatility.

4. Use key rate durations to compare a portfolio's yield curve exposure with its benchmark's and to estimate returns under curve scenarios.

KRDs measure sensitivity to one key rate with others unchanged; they sum to effective duration.
Scenario return is approximately minus the sum of KRD x yield change at each key rate.
Active curve exposure = portfolio KRD - benchmark KRD at each maturity.
Same total duration does not mean the same curve risk: compare KRD profiles.
KRDs depend on the key rates chosen and the interpolation used, and ignore spread risk.

5. Evaluate the expected return and risks of yield curve strategies, including inter-market strategies and the decision to hedge currency exposure.

Expected return = yield income + rolldown + expected price change from the yield view - expected credit losses + expected currency change.
Rolling yield = yield income + rolldown; it assumes an unchanged curve.
Hedged foreign bond return is approximately the local return + (domestic short rate - foreign short rate).
A higher foreign yield can vanish after hedging if foreign short rates are higher than domestic ones.
Inter-market trades are sized by BPV in each market and usually currency-hedged.

Module at a glance

Curve changes = level + slope + curvature; same-duration portfolios differ only in slope and curvature exposure.
Steepeners buy short and sell long in equal BPVs; flatteners do the reverse; butterflies isolate curvature.
If yields follow forwards, all maturities earn the short rate; static-curve views use buy-and-hold, rolldown and carry.
Rolling yield = yield income + rolldown; carry and rolldown lose sharply when the curve sells off.
Higher expected volatility: long convexity (barbells, long options, fewer callables and MBS); lower: the reverse.
Scenario return is approximately minus the sum of KRD x yield change; compare KRDs with the benchmark.
Hedged foreign return is approximately the local return + domestic short rate - foreign short rate.

This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.

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