Yield curve shift brings market relief
A quantitative analyst was recently asked to investigate the optimum place to invest on the yield curve to maximize the benefits of rolldown. Rolldown is the capital gain an investor captures as a bond’s maturity shortens and it moves to a lower-yielding point on the yield curve. This assumes an upwardly sloping yield curve, and the steeper the curve, the more rolldown one captures.
The analyst pulled in over 20 years of government bond data, sliced it into maturity buckets, and analyzed which buckets produced the greatest returns from rolldown over those years.
Investigation Results
The best performing bucket in Gilts and Treasuries was the 3-4yr, while in Bunds the 4-5yr bucket performed best. These short end buckets may have benefited from the greatest rolldown, but in a secular falling yield environment, they delivered lower total returns than the broader index and their longer-dated peers, due to being shorter duration.
When looking at the risk-adjusted returns, things become more interesting. The historic Sharpe Ratios of the lower duration buckets are meaningfully higher than the competition. This suggests that the short-dated buckets show their value to an investor when considering the volatility of returns.
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Exploiting the Results
One way to exploit these results is to buy more front end bonds to improve the risk-return characteristics of a portfolio. However, this would reduce the duration of the wider portfolio and leave it at risk of underperforming if yields were to fall over the next 20 years.
An alternative approach is to overweight the short-dated bucket and underweight the longer bucket, whilst maintaining a neutral duration across the portfolio. This approach more or less matches the performance of the overall index and reduces the volatility meaningfully.
The strength of outperformance clearly varies across £, €, and $, but in all cases having an overweight to the front end/steepest part of the yield curve generates better risk-adjusted returns. Rolldown can contribute meaningfully to a bond investor’s performance, and harvesting this can assist in beating passive exposure to fixed income markets.
In practice, this means that bond investors can potentially improve their returns by targeting the shorter end of the yield curve, while also managing their overall portfolio risk. By doing so, they can capture the benefits of rolldown and improve their risk-adjusted returns.
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It is clear that the analyst’s investigation has provided valuable insights into the benefits of rolldown. The findings suggest that investors can improve their returns by investing in the shorter end of the yield curve.
The results of the investigation have significant implications for bond investors. They can use this information to make informed decisions about their investments and potentially improve their returns.
Furthermore, the analysis highlights the importance of considering the trade-off between return and risk when investing in bonds. By carefully evaluating the potential benefits of rolldown and the associated risks, investors can make more informed decisions and optimize their investment strategies. Additionally, the use of metrics such as Sharpe Ratios can help investors to better understand the risk-adjusted returns of different investment options and make more informed decisions.
