Event: lower and higher duration yields rise, while those in the middle fall.
Net effect: asset portfolio decreases in value (due to lower and higher duration yields), while liability portfolio will increase in value.
Question: I guess we always measure our liabilities at a single point on the yield curve? In this case, the middle point is our reference, therefore our liabilities increase?
Way too many unknowns here… need more background information…There is a whole reading devoted to matching cash flows so its unlikely the author hasn’t made it clear what the nature of the liability is
But if your assumption that we are hedging a single x year duration liability with a barbell portfolio is right then your conclusion sounds right.
If the lower and higher yield rises, then that means the middle yield declines, which means a long barbell position will underperform, thereby leading to negative effect on the portfolio.
To take advantage of this decline in curvature, we should adopt a bullet portfolio structure by investing in the medium duration while shorting both the short and long duration bonds.
Cheers.
Just to be clear: y’all are talking about long, middle, and short _ maturities _, not (necessarily) long, middle, and short durations.
It’s unfortunate that “duration” sounds like it means “time to maturity”, when it actually means something quite different.
In the curriculum, if i have this right, Duration (if expressed in years) has been associated with zero coupon bonds (which is quite correct).
But from Level I days (Think it was last chapter of FI), i recall how they would emphasize to not confuse duration (IR sensitivity) of bonds with maturity (yrs) of bonds
Duration is always (or, rather, should always be) expressed in years; that’s the correct unit for Macaulay duration, modified duration, effective duration, key rate duration, spread duration, and so on. This is true whether you’re talking about zero coupon bonds, fixed (non-zero) coupon bonds, floating-rate bonds, amortizing bonds, MBS, whatever.
And except for Macaulay duration of zeroes, it is virtually never the case that the duration (whatever duration measure you mean) of a bond equals its time to maturity.
Thank you all for the clarification on duration versus maturity. It is an important distinction.
In the interest of exploring the topic, is there any situation where neglecting the distinction could result in making the wrong investment decision? Assuming, of course, that when you refer to x year duration bonds’ yields rising/falling, you don’t then go and sell/buy bonds with x years to maturity.
If you have long maturity, high coupon bonds vs. short maturity, low coupon bonds the duration of the former may be shorter than the duration of the latter.
Also, callable bonds (or, similarly, prepayable bonds such as MBS) may have very long maturities and short durations.