What Is a Roll-Down Return?
A roll-down return is a form of return that arises when the value of a bond converges to par as maturity is approached. The size of the roll-down return varies greatly between long- and short-term dated bonds. Roll-down is smaller for long-dated bonds that are trading away from par compared to bonds that are short-dated.
Roll-Down Return Explained
A bond investor can calculate the return on a bond in a number of ways. An investor can calculate the yield to maturity (YTM) on the bond, which is the rate of return earned on investment if the bond is held to maturity. You can also calculate return on investment by using the current yield, which is a measure of coupon payments based on the bond’s interest rate at the time the bond is purchased. Another method of looking into a bond’s earnings is the roll-down return.
The roll down return depends on the shape of the yield curve, which is the graphical representation of the yield for different maturities, from one month to 30 years. Assuming the yield curve is normal, that is upward sloping to the right, the rate you earn on longer-term bonds will be higher than the yield from short-term bonds.
The roll-down return is basically a strategy in which investors sell a bond as it approaches maturity. As time goes by, the bond yield falls and its price rises. Bond investors perceive more risk in lending for a longer time period than a shorter period and would, therefore, demand higher interest as compensation for investing in a long-term debt security. The initial higher interest rate of the long-term bond will decrease as maturity of the bond gets closer on the horizon. In general, the nearer to maturity a bond is, the lower the interest rate moves closer to zero. Since there is an inverse relationship between bond yields and prices, when interest rates decrease, bond prices increase as time passes.
For example, assume a 10-year Treasury yield is 2.46% and a 7-year yield is 2.28%. After three years, the 10-year bond will become a 7-year bond. Because the difference in yield between the 10-year and 7-year is 2.46% - 2.28% = 0.18%, the 7-year bond can rise 0.18% over three years before exceeding the investor’s yield to maturity, that is, 2.46%. Assuming that interest rates stay the same, this positive roll means that the price of the bond will go up as time passes. The roll-down return is the amount that interest rates can rise over a specified time period before the current yield exceeds an investor’s YTM. If the investor sells the bond, he will get more than he paid for it, in addition to the coupon payments already received. In effect, the investor earns money by rolling down the yield curve.
Roll-down return works two ways in respect to bonds. The direction depends on if the bond is trading at a premium or at a discount. If the bond is trading at a discount the roll-down effect will be positive. This means the roll-down will pull the price up towards par. If the bond is trading at a premium the opposite will occur. The roll-down return will be negative and pull the price of the bond down back to par.