What Is The “Rolling Down The Yield Curve” Strategy?

"Rolling down the yield curve" involves selling bonds before they come due to try to sell them at a higher price than what they're worth at maturity. Such a strategy can be effective in an investing environment marked by low interest rates and an upward sloping yield curve .

The strategy is based on the basic fact that bond prices and yields move in opposite directions. Since the yield on a bond will decline the closer it gets to maturity because it will be making fewer coupon payments, the exact opposite would also be true, i.e., the bond's price would rise in value, often above its maturity value.

This can be an effective strategy in an environment where interest rates are low but generally rising or are expected to rise. In this climate, many investors avoid long-term bonds and invest in short-term securities. However, this reduces their investment income, because short-term securities yield less than long-term bonds.

Rather, a possibly more effective strategy involves buying seasoned bonds with above-market coupon rates and selling them before their maturity date. Buying an older bond enables the investor to capture higher coupons while capitalising on the bond's rising price, while also minimising the risk of a capital loss, because the bond will mature in the near future.

Why Does This Strategy Work?

Bonds rise in price the closer they get to maturity for a few reasons. Because a bond makes coupon payments throughout its life, the more seasoned it is, the fewer payments it will be making, meaning its yield to maturity will go down. As a result, its price will go up.

By the same token, an older bond closer to maturity has less credit risk because it's less likely to default than a more recently issued bond that has many years to run. This may not be a factor in buying bonds issued by the United States and a few other countries, whose debt is considered "risk free," but it could be a factor with bonds issued by corporations and other less creditworthy entities.

As a result, a "rolling down the yield curve" strategy can work just as well, if not better, with highly rated corporate bonds than with government securities. The yield spreads between short- and long-term corporate bonds also tend to be wider than with government bonds.

Bonds closer to maturity are also generally less volatile and have shorter durations than other more recently issued bonds, further bolstering their price.

When Doesn't This Strategy Work?

The roll-down strategy doesn't work if the bond is trading at a premium, i.e., above par. That would mean the bond's price would decline as it approaches the maturity date. However, an investor may pursue this strategy if he is seeking a capital loss to offset other capital gains for tax purposes.

The strategy is also less effective in an inverted yield curve environment, when yields on short-term bonds are higher than on long-term bonds. However, while that does happen occasionally and over short periods, historically the yield curve is upward sloping.

Summary

"Rolling down the yield curve" is a bond market strategy in which the investor sells seasoned bonds at a premium prior to their maturity date. The strategy is based on the idea that as bonds get closer to their maturity date, their yield falls and therefore their price rises. The strategy is most effective when the yield curve is upwardly sloping and interest rates are low but rising.