CFA CFA level 3 CFA level 3 volume III applications of economic analysis and asset allocation finquiz smart summary, study session 12, reading 23

2018, Study Session # 10, Reading # 23

“YIELD CURVE STRATEGIES”
YC = yield curve

1. INTRODUCTION

Active yield curve strategies are the primary tool for
developing and implementing active fixed-income strategies.

2. FOUNDATIONAL CONCEPTS FOR ACTIVE MANAGEMENT OF YIELD CURVE STRATEGIES

2.2
Duration and
Convexity

2.1
A Review of Yield
Curve Dynamics

Three basic movements in the yield curve:
1) ∆ in level
2) ∆in slope
3) ∆in curvature
• If spread widens(narrows), the yield curve becomes
steepen (flatten)
• Negative value of spread results in inverted yield curve.
• Common measure of the yield curve curvature is the
butterfly spread.
Butterfly Spread = -(Short-term yield) + (2 x Medium-term
yield) – Long-term yield

• These three changes in the yield curve are interrelated.
Generally, for a(an):
↑ shift in level, the yield curve flattens and
becomes less curved.
↓ shift in level, the yield curve steepens and
becomes more curved.

• For a zero-coupon bond:
there is a linear relation b/w
Macaulay duration and
maturity.
Convexity ≈[duration]2.
• Coupon-paying bonds have higher
convexity as compared to zerocoupon bonds
• Convexity (+ve or -ve) is an important
factor in a bond portfolio’s return.

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2018, Study Session # 10, Reading # 23

3. MAJOR TYPES OF YIELD CURVE STRATEGIES
Active strategies have been categorized into the following two groups.
1. Active strategies under assumption of a stable yield curve
1) Buy & hold
2) Roll Down/Ride the Yield Curve
3) Sell Convexity
4) The Carry Trade
2. Active strategies for yield curve movement of level, slope, and curvature

1) Duration Management
2) Buy Convexity
3) Bullet & Barbell Structures

3.2
Strategies for Changes in Market
Level, Slope, or Curvature

3.1
Strategies under Assumptions of
a Stable Yield Curve

3.1.1
Buy & Hold

• constructing a
portfolio whose
features deviate from
the benchmark, & the
portfolio is held
constant for certain
time period.
• This is not a passive
strategy as it may
appear due to low
portfolio turnover.

3.1.2
Riding the Yield Curve

• An aggressive
version of buy &
hold strategy.
• The strategy works
if the YC is ↑
sloping & is likely
to remain static.
• This strategy is
based on the
concept of “roll
down”.

3.1.3
Sell Convexity

In anticipation of lower
future volatility or stable
yield curve, portfolio
returns can be enhanced
by reducing/selling the
portfolio convexity i.e.
receiving option
premiums by selling the
calls and puts on the
bonds.

3.1.4
Carry Trade

• Another strategy to position a

portfolio in anticipation of stable yield
curve.
• In a carry trade, manager purchases ↑
yield security, which is financed at a
rate ↓ than the yield on that security,
and earns the spread between the
two rates. This strategy frequently
involves ↑ leverage.
• Cross-currency carry trade implies
borrowing in a currency of a ↓ i-rate
country and investing proceeds in a
currency of a ↑ i- rate country.

3.2.2
Buy Convexity

3.2.1
Duration Management

3.2.3
Bullet & Barbell Structures

Managers ↓ (↑) portfolio duration
in anticipation of ↑ (↓) i-rates.
3.2.1.1
Using Derivatives to
Alter Portfolio Duration
Portfolio duration can be altered using futures
contract, leverage and interest rate swaps.
• Futures contracts are sensitive to changes

in the price of the underlying bonds and no
cash outlay is required except posting and
maintaining margin.
• To increase the portfolio duration, add
desired PVBP by purchasing bonds of any
duration through leverage.
• Interest rate swaps can be created for
every maturity; however, they are less
liquid than futures and less flexible than
using leverage. To lengthen(shorten)
duration add a receive-fixed (pay-fixed)
swap.

• is valuable when i-rates are
expected to be volatile.
• helps managers earning
additional return, without
altering the portfolio
duration.
• using options to enhance
portfolio convexity is an
alternative for managers
who find it difficult to ∆ the
portfolio structure easily.

• An active portfolio manager can shift the
portfolio to be more laddered (securities
distributed equally around various maturities),
bullet (securities concentrated around single
point on YC) or barbell (securities

concentrated at longer and shorter points).
• Bullet and barbell structures are the most
common approaches to benefit from nonparallel shifts in the YC.
• A bulleted portfolio will have little exposure
away from the target segment of the curve.
• A barbell portfolio exhibits higher convexity
than a bullet portfolio.
• Bullet (Barbell) structure is usually used to
take advantage of a steepening (flattening) YC.

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2018, Study Session # 10, Reading # 23

4. FORMULATING A PORTFOLIO
POSITIONING STRATEGY GIVEN
A MARKET VIEW

4.1
Duration
Positioning in
Anticipation of a
Parallel Upward
Shift in the Yield
Curve

4.2
Portfolio Positioning in
Anticipation of a Change

in Interest Rates,
Direction Uncertain

4.4
Using Options

4.3
Performance of DurationNeutral Bullets, Barbells,
and Butterflies Given a
Change in the Yield Curve

• Adding convexity using options
can be performed by selling
some bonds and purchasing call
options on those bonds in a way
that the portfolio’s effective
duration and market value
remains unchanged.
• Par value of the options = Par
value of the bonds sold

Manager can improve the
portfolio returns under such
scenario by ↑ the portfolio
convexity. i.e. if rates ↑ the
portfolio will bear ↓ losses
and if rates ↓, the gains will
be .

ì

ã The post trade portfolio
outperforms the pre-trade
portfolio when interest rate
change as long as the rate
change is greater than certain
basis points.
4.3.1
Bullets and Barbells

Consider two duration-matched
portfolios of equal market value, a
barbell portfolio containing 5-year bonds
and a bullet portfolio containing two
bonds of zero maturity and 10-year
maturity respectively.
If there is an instant ↓parallel shift in
the YC, barbell portfolio will
outperform bullet portfolio.
If the YC flattens in a way that shortterm rates ↑ and long-term rates
o remain unchanged, the barbell
portfolio will outperform the
bullet portfolio.
o ↓, the barbell portfolio will
outperform the bullet portfolio.
If the YC steepens, the bullet portfolio
will outperform the barbell portfolio.

4.3.2
Butterflies

• a long-short combination of bullet and
barbell portfolio structures.
• The butterfly structure is created by
taking position in three securities; shortterm, intermediate term and long-term.
• Two types of butterfly structures include:
Long barbell, short bullet – ↑
convexity position, benefit from a
flattening of the YC.
Long bullet, short barbell – ↓
convexity position, beneficial amid
stable interest rate prediction or
steepening of the YC.
• Some common ways to select the
weights of the butterfly wings are:
Duration neutral
50/50
Regression weighting

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4.4.1
Changing Convexity
Using Securities with
embedded Options

• Convexity can be ↓ by selling

options or buying MBS.
Buying MBS is equivalent to
selling call options as MBS
exhibits -ve convexity.
• If the YC is expected to
remain stable sell the
treasury bonds and purchase
MBS.
• Compared to treasury bonds,
MBS are more sensitive to ↑
in rates and less sensitive to ↓
in rates.


2018, Study Session # 10, Reading # 23

5. COMPARING THE PERFORMANCE OF VARIOUS DURATION-NEUTRAL
PORTFOLIOS IN MULTIPLE CURVE ENVIRONMENTS

Relative performance of Bullet and Barbell under different yield curve scenarios
Yield Curve Scenarios
Level ∆

Parallel Shift

Outperforms
Barbell

Slope ∆

Flattening
Steepening
Less
More
Decreased
Increased

Barbell
Bullet
Bullet
Barbell
Bullet
Barbell

Curvature ∆
Rate Volatility ∆

Underperforms
Bullet
Bullet
Barbell
Barbell
Bullet
Barbell
Bullet

6. A FRAMEWORK FOR
EVALUATING YIELD CURVE TRADES

Expected return can be decomposed into five sub-components.

This decomposition can help understanding the relative
contribution of each component in the performance of the
strategy.
E(R) ≈ Yield income + Rolldown return + E(∆ in price based on
investor’s views on yields and yield spread) −E(Credit losses) +
E(currency gains & losses)

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