I get it that we have to purchase bonds with maturities longer than the investment horizon. But as the bond approaches maturity, how do it is valued using lower yields.
The point of riding the yield curve is to capitalize on the higher yields and then sell/swap out the bond based on your time horizon. You do not let it approach maturity.
More specifically, if the YTM falls during your holding period, the price will rise by more than originally expected, so your holding period yield will be higher than expected.
It is because an originally 5-year bond issuance is valued exactly the same as an original 3-year bond when time has passed 2 years.
So, if your desired investment time horizon is 2 years and you buy a 5-year bond, by the time you sell your bond, you will not get the face value of the bond (say 1,000), but the current market price of a 3-year bond. Yes, your bond still has 3 years of remaining life.
For example: your 5-year bond was originally issued and valued at a price of 950 using the following yield curve:
2.0% 2.5% 3.0% 3.5% 4.0%
Assuming the yield curve has not changed, when 2 years has passed, the bond will be valued using this curve:
2.0% 2.5% 3.0%
The market price will be 985 (the price you ask when selling the bond, higher than 950). This is what it means “using lower yields”.
Also, there is the possibility the yield curve flattens (which is even better), so more capital gains on your bond.
Also, there is the possibility the yield curve steepens (which is bad…), so we can conclude riding a yield curve is a risky investment strategy despite of you buy a risk-free bond.
Hope this helps.
H