DEFINITION of Riding the Yield Curve
Riding the Yield Curve is a trading strategy that involves buying a long-term bond and selling it before it matures so as to profit from the declining yield that occurs over the life of a bond. Investors hope to achieve capital gains by employing this strategy.
BREAKING DOWN Riding the Yield Curve
The yield curve is a graphical illustration of the yields of bonds with various terms to maturities. The graph is plotted with interest rates on the y-axis and increasing time durations on the x-axis. Since short-term bonds typically have lower yields than longer term bonds, the curve slopes upwards from the bottom left to the right. This term structure of interest rates is referred to as a normal yield curve. For example, the rate of a one-year bond is lower than the rate of a 20-year bond in times of economic growth. When the term structure reveals an inverted yield curve then short-term yields are higher than longer term yields, implying that investors’ confidence in economic growth is low.
In bond markets, prices rise when yields fall, which is what tends to happen as bonds approach maturity. To take advantage of declining yields that occurs over a bond’s life, investors can implement a fixed income strategy known as riding the yield curve. Riding the yield curve involves buying a security with a longer term to maturity than the investor's expected holding period in order to produce increased returns. An investor’s expected holding period is the length of time an investor plans to hold his investments in his portfolio for. According to an investor’s risk profile and time horizon, he may decide to hold a security short-term before selling or hold long-term - more than a year. Typically, fixed income investors purchase securities with a maturity equal to their investment horizons and hold to maturity. However, riding the yield curve attempts to outperform this basic and low risk strategy.
When riding the yield curve, an investor will purchase bonds with maturities longer than the investment horizon and sell them at the end of the investment horizon. This strategy is used in order to profit from the normal upward slope in the yield curve caused by liquidity preferences and from the greater price fluctuations that occurs at longer maturities. In a risk-neutral environment, the expected return of a 3-month bond held for three months should equal the expected return of a 6-month bond held for three months and then sold at the end of the three-month period. In other words, a portfolio manager or investor with a three-month holding period horizon may buy a six-month bond, which has a higher yield than the three-month bond, and then sell the bond at the three-month horizon date.
Riding the yield curve is only more profitable than the classic buy-and-hold strategy if interest rates stay the same and do not increase. If rates rise, then the return may be less than yield that results from riding the curve and could even fall below the return of the bond that matches the investor’s investment horizon, thereby, resulting in a capital loss. In addition, this strategy produces excess returns only when longer-term interest rates are higher than shorter-term rates. The steeper the yield curve's upward slope at the outset, the lower the interest rates when the position is liquidated at the horizon, and the higher the return from riding the curve.