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Subject 2. Yield Curve Movement, Forward Curve and Rolling Down the Yield Curve PDF Download
The forward contract price remains unchanged as long as future spot rates evolve as predicted by today's forward curve. If forward rates are realized, then all bonds, regardless of maturity, will have the same one-period realized return, which is the first-period spot rate.

If the spot rate curve is upward sloping and is unchanged, then each bond "rolls down" the curve and earns the forward rate that rolls out of its pricing. This implies an expected return in excess of short-maturity bonds for longer-maturity bonds if the yield curve is upward sloping.

Example

Assume the following spot rates for a 3.5% annual coupon bond.

1-year: 0.5%
2-year: 0.7%
3-year: 1.0%
4-year: 1.2%
5-year: 1.5%
6-year: 1.8%
7-year: 2.0%
8-year: 2.2%
9-year: 2.5%
10-year: 3%

Buy & Hold Strategy: The price of a 5-year, 3.5% annual coupon bond is $1,097.43. The IRR, after considering the annual coupon of $35, will be 1.465%.

Rolling Down the Yield Curve Strategy: The price of a 10-year, 3.5% coupon bond is $1,058.66. Five years later, if interest rates remain the same throughout the yield curve, the investor could sell that 10-year bond at a price of $1,097.43. The IRR, after considering the annual coupon of $35, will be 3.98%.

At first glance, this strategy sounds like the proverbial "free lunch", but it has a logical explanation. If the investor were to hold the bond to maturity, the investor would have a security whose yield decreases over time. This lower yield reflects the fact that the price volatility of the bond, in other words, its market risk, would also be decreasing. The principle in operation here is that the maturity of a bond affects how much the price changes in response to changing interest rates: the shorter the maturity, the less the change. By swapping into a longer bond, the investor replaces a lower yielding security with a higher yielding security. This higher yield compensates for the fact that the new bond has greater price volatility.

Note two important assumptions:

  • The yield curve retains its current slope.
  • The interest rates do not increase.

User Contributed Comments 1

User Comment
3721 A shorter-term bond will lose less value if interest rates increase, and there's less chance of default. Basically, investors are willing to pay more, or accept a lower yield, on a shorter-term bond because there is less risk.

The biggest risk with this strategy is overall market interest rates increasing. The longer the maturity of the bond, the smaller the increase in interest rates that is needed to turn the "rolling down the yield curve" strategy into a losing investment.
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Craig Baugh

Craig Baugh

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