In CFA curriculm, volume 4, page 228, the book described how to construct am enhaced equity indexed throught derivative-based. To generate anpla, investor invest in fixed income typically in order to alter duration of cash position.
However, it said " when this segment of the yield curve slopes steeply, the manager should invest in longer-duration fixed income, because the higher yield compensates the investor for the increased risk". I don’t know why we should invest in longer-duration fixed income when yield curve slope as the bond’s price would decrease in that case? even the longer-duration may have greater impact. Please explain it.
It basically means that when you are having high yields, by taking long duration you are basically locking yourself at a higher yield for a longer duration of time. So lesser the reinvestment risk of the cash position…
I think that active management ultimately depends on manager’s forecast. In this case he must be betting that the slope will be less steep in the future hence locking in the higher yield now and hoping that the higher risk will not materialise.
Yeah. If its a flat yield curve, no point incurring additional interest rate risk so take the short term instruments. If its sloping upwards you’ll get more return on the cash by investing in the longer term bond (higher duration).
Would appreciate some confirmation of the below:
Whatever return u get on the fixed income investments will be in addition to the long index futures position which makes it an enhancement over a simple index return - that’s how I see it. Is this perspective correct? i.e. instead of adjusting the index weights, you’ll just take them as they are and attempt to modify the return through fixed income.
" I don’t know why we should invest in longer-duration fixed income when yield curve slope as the bond’s price would decrease in that case? even the longer-duration may have greater impact. Please explain it."
yield curve steep means - 5yr 6% and 7yr - 9% for example…just by extending duration by 2 yrs you are locking 300bp excess yield.
Your comment makes me think that you see an implied price risk. I dont think so…rather counterparty risk because you are holding the instrument to maturity or extending the duration of your portfolio.
I believe when you want to reduce the duration you end up selling and then you are subject to price risk.
implied price risk is great if rates are expected to rise in general.
A twist in the yield curve , where the long duration is rising sharper than the short duration is rising is an opportunity to a manger that is expecting the long to revert to more normal levels .
If the short stays lower eventually the long bond will flatten somewhat , benefiting the manager who anticipates this and increases the duration of his position.
It is not necessarily a reinvestment opportunity, because reinvestment happens at the short er duration than the original long duration. A rising-slope curve is not an opportunity for reinvestment because successive cash flows are being reinvested at lower rates , compared to the original long rate
I thought that if you expect the yield curve to steepen, than you want to sell longer duration bonds and invest in shorter duration securities - to mitigate the interest rate risk associated with increasing rates. And vice versa if you expect yields to decrease. What gives?
If the yield curve is rising in a parallel fashion , the right place to be is in the short end.
However if the short stays low(er) and the long is rising , it could represent an opportunityif the manager suspects that longer term the long end will revert ( flatten ) . i.e. it could be case of the manager buying low ( price ) and selling high ( price ) when the reversion occurs . Also it doesn’t hurt to be receiving larger interest cash flows for the longer duration bond . The book alludes to taking risk ( expecting reversion and ultimate domination ) in order to earn higher rewards
Thank all you guys for heplful responses. I think explanation of sooraj and ov25 made sense to me and easy to understand.
@janakisri: I understand your answer that the manager should be able to predict a steep slop will revert eventually in future and invest in longer duration will take advantage of such reversal? Is this what you mean?
“It basically means that when you are having high yields, by taking long duration you are basically locking yourself at a higher yield for a longer duration of time. So lesser the reinvestment risk of the cash position…Hope this helps…”
Are you referring to cashflow yield otherwise known as coupon ?
There is no guarantee that the total return for such an instrument is commensurate with the risk . For example high yield ( high coupon ) bond may be discounted less so it is priced higher . When rates go up the price of the same bond goes down , so your price return would be negative , cancelling the effect of the high coupon.
. So the only reason you would get into higher priced bond ( relative to low duration and low coupon bond ) is if you think the price is justified because interest rates will go down especially the interest rate for the bond you purchased . That will keep the price of the bond from sinking .
So it is the manager’s assesment of where the rates will go from here that drives the purchase decision , not only the fact that yield is high at the long duration.