Q. You’re at the Investment Managers Consultant Association annual meeting, and folks are talking about how to generate current yield in this the super low interest rate environment… but one idea is something called a “roll down” strategy?
A. That’s right. The strategy starts with the observation that the yield curve is pretty steep right now…. that is, short maturity bonds have much lower yields than long maturity bonds do. Now, as time passes, longer maturity bonds become shorter maturity– we get closer to any bonds actual maturity date every day, obviously. As long term bonds progressively become shorter term by the passage of time, there’s an opportunity for investors to “roll down” the yield curve and make some money.
Q. Wait… how does that work, exactly? The bond’s coupon obviously doesn’t change, so how is the extra money getting made?
A. Of course, a bond that was issued with a 5 year maturity 2 years ago has 3 years left to maturity. It should have the same yield as a newly issued 3 year bond, of course. Since its stated coupon rate does not change, the only way for that to be true is for the price of the 5 year bond to go up… so, the investor gets capital appreciation that way.
Q. I see… as a longer dated, higher coupon bond “rolls down” the yield curve, its price has to go up to keep its yield in line with newly issued bonds that mature on the same date.
A. Right. And the appreciation can be meaningful, especially given how low rates are for shorter dated instruments…. Right now, a 7 year bond might appreciate 80 bps over a six month period because of this phenomenon.
Q. But of course, that assumes no change in the shape of the yield curve…
A. Definitely right. If the yield curve flattens from here, you won’t get the benefit of a “roll down”. But at least, for now, this is a way of generating somewhat higher total returns out of a fixed income portfolio in a low rate environment.