Managing Money via the Yield Curve
March 3, 2008
The changing market conditions and interest rates often make it necessary for you to improve the yield on your investment portfolio. You can achieve this result by trading out of one investment instrument and putting the proceeds into another investment instrument without departing from your other basic investment guidelines. Trading in securities this way is referred to as “riding the yield curve.”
Basically, a yield curve is just a graphic illustration of the current yields-to-maturity available at a given time on various maturities of a specific category of debt securities. Such knowledge allows you to adjust and react to predictable market trends and interest-rate movements. Interest rate trends directly affect securities, especially debt instruments.
The yield curve graph can be downward sloping, horizontal, upward sloping, or humped. Each type of yield curve portrays the prevailing supply and demand conditions and market expectations at a given time. The developments that determine the shape of a curve and its level in relation to others have significant implications for an investment strategy.
An upward sloping curve of the yield reflects the following: yields on short-term maturities are lower than those on long-term maturities; relative greater supply of short-term funds than long-term funds; expectations of a possible future rise in yields; and monetary and fiscal policies favoring an easing in short-term rates.
A horizontal pattern of the yield curve indicates four factors at work: a narrowing of yield spreads among short-term, medium-term, and long-term maturities; an approximate balancing of demand and supply forces; investor expectations favoring an eventual decline in rates; and monetary and fiscal policies influencing short-term rates upward while pushing long-term rates downward to encourage business investment and housing activity.
When the yield curve is exhibiting a downward slope, it reflects that yields on short-term maturities are higher than those on the longer-term maturities. During such periods, strong demand prevails for short-term funds, while the supply of such funds is limited. Tight fiscal and monetary policies, as well as investor expectations of future declines in interest rates, also influence the shape there. The skewed or humped curve results when yields are expected to go higher over the next several years, reach a peak, and then decline until they finally level out in later maturities.
Riding the yield curve has often been described as a sure method for guaranteed higher returns. That description is a bit misleading. It is a useful technique and can indeed lead to greater returns if used correctly. Timing is absolutely critical. But remember that a marketable security need not be held to maturity. However, the longer the length to maturity, the greater the potential price fluctuation and the higher the potential gain or the risk of loss.
For example, where the shape of the yield curve is inverse, featuring highest yields at 8 percent and then declining to 7 percent at 2.5 years and flattening in the 7 percent range from 5 to 23 years, you would likely see significant changes in the short maturity range. You would also expect to see a flattening of the yield curve in the following 2 to 3 months with trading under 7 percent. Under those conditions, it would not be necessary to extend the term beyond the money market area unless there are opportunities to acquire optional maturity bonds that offer both short and extended yields on the existing yield curve for outstanding issues.
Take, for example, an investment portfolio that comprises one-year Treasury bills and AAA corporate bonds due in 2009, extendible until 2014. This portfolio ensures that its fixed-income portion will achieve excellent income, liquidity, and capital preservation. The Tbills will eliminate the prospect of rolling over three month bills at lower rates of maturity, thus entering a better income performance. The extendible bonds are well positioned to participate in whatever yield improvements that do occur along the 5- to 10-year portion of the curve over the following year.
The yield curve is primarily an information tool and is charted by major brokerage houses for their consultation and for use by their clients. By referencing a yield curve, you can identify the securities that are most attractive for buying or selling, which are those that present profitable trading opportunities on a favorable shift in the overall interest rate structure.
Your decisions to lengthen or shorten maturities of your investments are influenced by the existing curve and by your expectations about the shape and position of future curves. And just like the big institutions, you’ll know how to make timely judgments regarding debt instruments by riding the yield curve.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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