From a yield curve perspective for bonds, and investing based on expectations of changing interest rates, I have 2 clarifications:
a. Is the investment manager’s focus on better rate or better price (since they are inversely related)? Let’s say short term rates are expected to fall but long term rates are expected to remain higher, curriculum says manager will invest in long term bonds due to higher rate. Why wouldn’t the manager invest in short term bonds, the prices of which are expected to ‘increase’ when their rate falls?
b. When the yield spread between long and short duration bonds is expected to narrow, long duration bonds are expected to outperform, and when this spread is expected to widen, short duration bonds are expected to outperform (per curriculum). I don’t understand why this the case.
For a. I would agree that you would want to invest in short term bonds under that scenario if you were trading based on the changing rates and not trying to match liabilities, or yield etc.
For b. The narrowing of the spread over short duration means the long rates are coming down more than the short rates, therefore longer duration with a declining interest rate will outperform. When the spread is widening, the longer rates are moving up faster than the short rates, therefore shorter duration bonds will outperform long bonds
a) I think the manager will invest in the longer term bonds due to the higher YTM. The steeper yield curve would be attractive because using the higher proceeds from a higher yield - investors could acquire long term bonds and can invest the proceeds in shorter term treasuries later.
b) Long duration bonds are more sensitive to changes in interest rates (per the following forumla):
-MDUR * % change in yield. If a long-term bond has a duration of 8.0 and rates decrease by 1%, the change in price would be -8*(-.01) = 8%. If a short term bond has a duration of 2.0 and rates decrease by 1%, the change in price would be -2*(-.01) = 2%. Therefore long-term bonds are more attractive in that scenario. When spread widens, short term bonds will outperform long-term bonds because they are less sensitive to the change in rates. Using the same example above, long duration bonds would decrease by 8% and short-term bonds would only decrease by 2%, given a 1% change in yield.
a) if steeper yield curve would mean long term interest rates > st int rates thus long term bonds price will decrease due to larger increases in interest rates (that’s how they explain it in more than problem accress am sessions).