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2023 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

Yield Curve Strategies

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Introduction

The size and breadth of global fixed-income markets, as well as the term structure of interest rates within and across countries, lead investors to consider numerous factors when creating and managing a bond portfolio. While fixed-income index replication and bond portfolios that consider both an investor’s assets and liabilities were addressed earlier in the curriculum, we now turn our attention to active bond portfolio management. In contrast to a passive index strategy, active fixed-income management involves taking positions in primary risk factors that deviate from those of an index in order to generate excess return. Financial analysts who can successfully apply fixed-income concepts and tools to evaluate yield curve changes and position a portfolio based upon an interest rate view find this to be a valuable skill throughout their careers. 

Prioritizing fixed-income risk factors is a key first step. In what follows, we focus on the yield curve, which represents the term structure of interest rates for government or benchmark securities, with the assumption that all promised principal and interest payments take place. Fixed-income securities, which trade at a spread above the benchmark to compensate investors for credit and liquidity risk, will be addressed later in the curriculum. The starting point for active portfolio managers is the current term structure of benchmark interest rates and an interest rate view established using macroeconomic variables introduced earlier. In what follows, we demonstrate how managers may position a fixed-income portfolio to capitalize on expectations regarding the level, slope, or shape (curvature) of yield curves using both long and short cash positions, derivatives, and leverage.

Learning Outcomes

The member should be able to:

  • describe the factors affecting fixed-income portfolio returns due to a change in benchmark yields;
  • formulate a portfolio positioning strategy given forward interest rates and an interest rate view that coincides with the market view;
  • formulate a portfolio positioning strategy given forward interest rates and an interest rate view that diverges from the market view in terms of rate level, slope, and shape;
  • formulate a portfolio positioning strategy based upon expected changes in interest rate volatility;
  • evaluate a portfolio’s sensitivity using key rate durations of the portfolio and its benchmark;
  • discuss yield curve strategies across currencies;
  • evaluate the expected return and risks of a yield curve strategy.

Summary

This reading addresses active fixed-income yield curve management using cash- and derivative-based strategies to generate returns which exceed those of a benchmark index due to yield curve changes. The following are the main points in the reading:

  • A par yield curve is a stylized representation of yields-to-maturity available to investors at various maturities, which often does not consist of traded securities but must be extracted from available bond yields using a model.
  • Primary yield curve risk factors may be categorized by changes in level (or a parallel “shift”), slope (a flatter or steeper yield curve), and shape or curvature.
  • Yield curve slope measures the difference between the yield-to-maturity on a long-maturity bond and the yield-to-maturity on a shorter-maturity bond. Curvature is the relationship between short-, intermediate-, and long-term yields-to-maturity.
  • Fixed-income portfolio managers can approximate actual and anticipated bond portfolio value changes using portfolio duration and convexity measures. Duration measures the linear relationship between bond prices and yield-to-maturity. Convexity is a second-order effect describing a bond’s price behavior for larger rate movements and is affected by cash flow dispersion.
  • A barbell portfolio combining short- and long-term bond positions will have greater convexity than a bullet portfolio concentrated in a single maturity for a given duration.
  • Active managers seeking excess return in an expected static yield curve environment that is upward-sloping can use a buy-and-hold strategy to increase duration, roll down the yield curve, or use leverage via a carry trade in cash markets. Receive-fixed swaps and long futures positions replicate this exposure in the derivatives market.
  • Derivatives offer the opportunity to synthetically change exposure with a far smaller initial cash outlay than cash strategies but require managers to maintain sufficient cash or eligible securities to fulfill margin or collateral requirements.
  • Active fixed-income managers with a divergent rate level view increase duration exposure above a target if yields-to-maturity are expected to decline and reduce duration if expecting higher yields-to-maturity to minimize losses.
  • Yield curve steepeners seek to gain from a greater spread between short- and long-term yields-to-maturity by combining a “long” short-dated bond position with a “short” long-dated bond position, while a flattener involves sale of short-term bonds and purchase of long-term bonds.
  • Steepener and flattener strategies may be net duration neutral or net long or short duration depending upon a manager’s view of how the yield curve slope will change—that is, the relative contribution of short- and long-term yield-to-maturity changes to the expected yield curve slope change.
  • The butterfly strategy combining a long bullet with a short barbell portfolio (or vice versa) is commonly used to capitalize on expected yield curve shape changes.
  • Active managers capitalize on a view as to whether future realized interest rate volatility will be greater or less than implied volatility by purchasing or selling bonds with embedded options or by using stand-alone interest rate options.
  • Stand-alone interest rate put and call options are generally based upon a bond’s price, not yield-to-maturity.
  • Interest rate swaptions and options on bond futures are among the common tools used by active managers to alter portfolio duration and convexity subject to yield-to-maturity changes. An interest rate swaption involves the right to enter into an interest rate swap at a specific strike price in the future, while an option on a bond future involves the right, not the obligation, to buy or sell a futures contract.
  • Key rate durations can be used in active fixed-income management to identify a bond portfolio’s sensitivity to changes in the shape of the benchmark yield curve, allowing an active manager to quantify exposures along the curve.
  • Fixed-income managers engaged in active yield curve strategies across currencies measure excess return from active management in functional currency terms—that is, considering domestic currency returns on foreign currency assets within a portfolio.
  • Interest rate parity establishes the fundamental relationship between spot and forward exchange rates, with a higher-yielding currency trading at a forward discount and a lower-yielding currency trading at a premium.
  • Covered interest rate parity involves the use of a forward contract to lock in domestic currency proceeds, while uncovered interest rate parity suggests that over time, the returns on unhedged foreign currency exposure will be the same as on a domestic currency investment.
  • Active investors use the carry trade across currencies to take advantage of   divergence from interest rate parity by borrowing in a lower-yield currency and investing in a higher-yield currency.
  • A cross-currency swap enables investors to fully hedge the domestic currency value of cash flows associated with foreign currency bonds.
  • Active managers deviate from fully hedged foreign currency bond cash flows by entering overweight and underweight bond positions denominated in different currencies, often using an underweight position in one currency to fund an overweight position in another.
  • Investors evaluate the expected return on an active fixed-income portfolio strategy by combining coupon income and rolldown return with expected portfolio changes based on benchmark yield-to-maturity, credit, and currency value changes over the investment horizon.
  • Unexpected market changes or risks to portfolio value are frequently evaluated using scenario analysis.