What Is 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.
As a trading strategy, riding the yield curve works best in a stable interest rate environment where interest rates are not increasing. Additionally, the strategy only produces excess gains when longer-term interest rates are higher than shorter-term rates.
Key Takeaways
- Riding the yield curve refers to a fixed-income strategy where investors purchase long-term bonds with a maturity date longer than their investment time horizon.
- Investors then sell their bonds at the end of their time horizon, profiting from the declining yield that occurs over the life of the bond.
- For example, an investor with a three-month investment horizon may buy a six-month bond because it has a higher yield; the investor sells the bond at the three-month date, but profits from the higher six-month yield.
- If interest rates rise, then riding the yield curve is not as profitable as a buy-and-hold strategy.
How Riding the Yield Curve Works
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, this means 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 occur 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 bond with a longer term to maturity than the investor's expected holding period in order to produce increased returns.
Advantages of Riding the Yield Curve
An investor’s expected holding period is the length of time an investor plans to hold his investments in his portfolio. According to an investor’s risk profile and time horizon, they may decide to hold a security short-term before selling or to 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 occur 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 buys a six-month bond—which has a higher yield than the three-month bond—and then sells the bond at the three-month horizon date.
Special Considerations
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 the 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.
FAQs
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.
What does it mean to play the yield curve? ›
The yield curve allows fixed-income investors to compare similar Treasury investments with different maturity dates as a means to balance risk and reward. Additionally, investors use its shape to help forecast interest rates.
Is buy and hold the same as riding the yield curve? ›
Riding the yield curve implies selling the bond before maturity. Buy and hold implies holding the bond to maturity.
What does it mean when the yield curve is humped? ›
A humped yield curve is a relatively rare type of yield curve that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments. Also, if short-term interest rates are expected to rise and then fall, then a humped yield curve will ensue.
What are the risks of riding the yield curve? ›
If rates rise, then the return may be less than the 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.
What is the yield curve for dummies? ›
What Is a Yield Curve? A yield curve is a line that plots yields, or interest rates, of bonds that have equal credit quality but differing maturity dates. The slope of the yield curve can predict future interest rate changes and economic activity.
How does yield curve predict recession? ›
The yield curve — the difference between yields of 10- and two-year US Treasuries — has long been seen as a predictor of recession: When investors are fearful, they tend to buy up 10-year Treasuries, causing the yield to fall below the interest rate of shorter-term securities.
What happens when the yield curve goes down? ›
Sometimes a yield curve can invert and start sloping downward. When this happens, short-term bonds have higher yields than long-term bonds, and investors are not rewarded for parting with their money for longer periods.
What moves the yield curve? ›
Changes in the cash rate tend to shift the whole yield curve up and down, because the expected level of the cash rate in the future influences the yield investors expect from a bond at all terms.
Does a yield curve inversion mean a recession is coming? ›
The event – commonly dubbed a yield curve inversion – was largely viewed as a signal the U.S. economy would likely slip into recession in the near future. An inverted yield curve occurs when short-term yields on U.S. Treasurys exceed long-term yields on Treasurys.
While the inverted yield curve does not serve as a forecast for a recession, it's certainly an indicator tied to recessions, but investors should look at the economy as a whole including other factors such as inflation, job reports and wage growth before reaching the conclusion that we are in a recession.
Why does yield go down when price goes up? ›
As the price of a bond goes up, the yield decreases. As the price of a bond goes down, the yield increases. This is because the coupon rate of the bond remains fixed, so the price in secondary markets often fluctuates to align with prevailing market rates.
Why is a steep yield curve bad? ›
Steepening Yield Curve
Steepening yields are a true risk for bond traders who use a roll-down return strategy to profit from selling long-term bonds they hold. A steepening curve typically indicates stronger economic activity and rising inflation expectations, and thus, higher interest rates.
What does a steep yield curve look like? ›
A steep yield curve looks like a normal yield curve but with a steeper slope. Market conditions are similar for normal and steep yield curves. But a steeper curve suggests investors expect better market conditions to prevail over the longer term, which widens the difference between short-term and long-term yields.
What would cause the yield curve to be ascending? ›
The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. An upward sloping yield curve suggests an increase in interest rates in the future.
Does yield curve predict recession? ›
The yield curve — the difference between yields of 10- and two-year US Treasuries — has long been seen as a predictor of recession: When investors are fearful, they tend to buy up 10-year Treasuries, causing the yield to fall below the interest rate of shorter-term securities.
Is the yield curve a good indicator? ›
broad literature originating in the late 1980s documents the empirical regularity that the slope of the yield curve is a reliable predictor of future real economic activity.
What is a good yield curve? ›
The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape, and it's sometimes referred to as the "positive yield curve."
What happens when the yield curve goes up? ›
A steepening curve typically indicates stronger economic activity and rising inflation expectations, and thus, higher interest rates. When the yield curve is steep, banks are able to borrow money at lower interest rates and lend at higher interest rates.
