Trading the Yield Curve: Taking Advantage of the Term Structure of Interest Rates

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Trading the Yield Curve: Taking Advantage of the Term Structure of Interest Rates

This article was preceded by “The Term Structure of Interest Rates” which explains the creation of the yield curve and the term structure of interest rates. Study of the yield curve can offer hints as to what rates along the yield curve are rising and falling as a result of changes in the economy.

Credit Spread Relationships in the Bond Markets

  • During periods of stable economic growth the yield of government or top rated securities will be narrower with respect to other investment grade bonds. Speculative bonds are enjoying improving and stable cash flows and may even hold out the possibility of upgrades. As a result, during these better times the yield curve of high quality credits and medium and speculative credits tend to converge. Investors may downgrade their portfolios for more yield as credit conditions are not yet tightening. This period coincides with the beginning of economic expansion. The yield curve is generally sloping at this point and rising with the general pick-up of economic activity.
  • As the economy expands, yields increase due to credit pressures but the increased level of profit and general economic activity improves credit ratings of lesser credits at a faster rate. The yield curve is flattening as increased pressure from short term credit demands rises faster than inflation premiums for intermediate and long bond maturities.
  • Approaching the end of an economic cycle yield spreads are starting to widen again as unexpected news and concerns about the future begin to affect weaker credits. Astute portfolio managers, given the strength in the bond market may choose to sell stock at this time and retire debt. The declining outlook for profits and hence declining inflation result in long term rates dropping while short term rates remain higher due to inventory pressures.
  • The economy enters a recession with an inverse relationship between long and short rates. Fears of credit downgrades and bankruptcy, and a general risk aversion to weaker credits causes yield spreads to widen even as the general level of interest rates decline from slower economic activity.
  • At the trough of the recession, with short term debt pressures removed, the yield curve is barely positive or upward sloping. This reflects lack of economic activity, low inflation fears, and a dismal economic outlook. The flight to quality bonds is peaking, leaving speculative bonds with few buyers.

Bond Managers Buy Bonds According to Cash Flow

Unlike a stock portfolio manager, bond managers are expected to be in a long bond position and nearly fully invested all the time. This is because bond investors expect to reap regular coupon income throughout business cycles. In addition, bond managers know that it is coupon or current income that brings in new bond buyers into their fund.

The opportunity for bond managers is to use the trend changes in trading periods described above to safely increase yield by downgrading the credit rating of bonds they purchase. They then may protect asset values by selling lesser credits for strong credits during recessionary times.Rarely does a portfolio manager buy bonds and hold them to maturity.

Bond Managers Use Term Structure Not Economic Forecasts to Guide Decision-Making

Economists float theories and interpretations of events every day. Until there is a decided shift in the behavior of the bond buyer as evidenced by the changing shape of the yield curve the portfolio manager will wait for evidence of economic changes to appear. The cost of a portfolio manager to trade his own economic forecasts is futile. Safer and more secure is to react to the picture formed by the yield curve.