Rolling Down the Yield Curve
A SIMPLE STRATEGY FOR BOOSTING FIXED INCOME RETURNS: ROLLING DOWN THE YIELD CURVE In a low rate environment, fixed income investors naturally fear the possibility of an increase in interest rates. To minimize the risk of principal loss, many investors choose a strategy of investing in money market or other short term fixed income securities. While this does minimize the potential for unanticipated capital loss when proceeds are needed, this strategy also reduces investment income due to the low yields at the shortest end of the yield curve. Not only are these instruments generating historically low returns, but the after-tax real return may in fact be negative. Fortunately, there is an alternative strategy for fixed income investing that generates higher returns yet still minimizes the risk of principal loss. In this paper, we explore the strategy of “rolling down the yield curve” and highlight the utility of RBC Target Maturity Corporate Bond Index (TMCB) ETFs in implementing the strategy.
The Strategy: “Rolling Down the Yield Curve” One of the attractive features of bonds is the clarity they provide on cash flows, and therefore the ability to model their total investment performance under different interest rate environments. This modeling capability, along with the passage of time, can be used to the investor’s advantage. In an upward sloping yield curve and low rate environment, an opportunity exists to earn higher yields, while still minimizing the risks to principal. The strategy, known as “rolling down the yield curve”, involves the purchase of a bond with a maturity in the higher yielding section of the yield curve and selling the bond prior to maturity when it reaches a lower yielding section. The strategy can benefit investors by providing: 1. Higher incremental income: By purchasing relatively higher yielding bonds 2. Higher principal proceeds at liquidation: Depending on the characteristics of the bond, a capital gain or reduced capital loss 3. Declining bond price volatility as the bond moves close to maturity.
Implementing the Strategy with RBC Target Maturity Corporate Bond Index ETFs The table below illustrates the excess returns produced by purchasing a longer duration RBC TMCB ETF and selling it one year prior to maturity, rather than purchasing a shorter duration ETF and holding it to maturity. For example, if an investor intends to purchase RQE (maturing in 2017) the annualized return after MER would be 2.43%. Utilizing the “rolling down the yield curve” strategy, the investor would purchase RQF (maturing in 2018), sell it in 2017 and generate an annualized return of 3.00%. This provides the investor with an excess annual return of 57 Bps, enhancing total returns by 23%. For the purposes of this exhibit, we assume that interest rates remain unchanged. Assumes No Increase/Shift in the Yield Curve (at January 31, 2012) Security Symbol
Maturity Year
Current Yield
2013 2014 2015 2016 2017 2018 2019 2020
1.45% 4.59% 4.46% 3.89% 4.15% 4.17% 4.72% 4.66% 4.48%
1 Year Bankers Acceptance
RQA RQB RQC RQD RQE RQF RQG RQH
Purchased Yield Total Return to Total Return to Ann. Return to Annualized Excess Return from to Maturity Maturity 1 Year Prior 1 Year Prior Buying Longer Duration and (after MER) (after MER) to Maturity to Maturity Selling 1 Year Prior to Maturity
1.45% 1.44% 1.89% 2.17% 2.36% 2.43% 2.77% 2.86% 2.91%
1.45% 2.90% 5.79% 8.95% 12.37% 15.47% 21.11% 25.33% 29.47%
1.43% 4.28% 7.39% 10.76% 13.82% 19.38% 23.54% 27.62%
1.43% 2.12% 2.40% 2.59% 2.62% 3.00% 3.07% 3.10%
-0.02% 0.68% 0.51% 0.42% 0.26% 0.57% 0.29% 0.23%
Purchasing the 2017 bond and holding it until maturity would produce an annualized return of 2.43%. Purchasing the 2018 bond and selling it in 2017 results in a 0.57% increase in annualized return.
Rolling Down the Yield Curve
What if interest rates rise? Interest rates do fluctuate, so what is the impact to the strategy if interest rates were to rise dramatically? Below we extend our analysis by examining a scenario in which interest rates increase by 150 bps during the holding period. Excess Returns with a 150 Bps Increase/Shift in the Yield Curve (at January 31, 2012) Security Symbol
Maturity Year
Current Yield
2013 2014 2015 2016 2017 2018 2019 2020
2.95% 4.59% 4.46% 3.89% 4.15% 4.17% 4.72% 4.66% 4.48%
1 Year Bankers Acceptance
RQA RQB RQC RQD RQE RQF RQG RQH
Purchased Yield Total Return to Total Return to Ann. Return to Annualized Excess Return from to Maturity Maturity 1 Year Prior 1 Year Prior Buying Longer Duration and (after MER) (after MER) to Maturity to Maturity Selling 1 Year Prior to Maturity
2.95% 1.44% 1.89% 2.17% 2.36% 2.43% 2.77% 2.86% 2.91%
2.95% 2.90% 5.79% 8.95% 12.37% 15.47% 21.11% 25.33% 29.47%
-0.05% 2.76% 5.82% 9.15% 12.16% 17.64% 21.74% 25.76%
-0.05% 1.37% 1.90% 2.21% 2.32% 2.75% 2.85% 2.91%
-3.00% -0.07% 0.01% 0.05% -0.04% 0.32% 0.08% 0.04%
Even with a 150 Bps shift in the yield curve, the strategy produces virtual break-even, if not positive results.
This table demonstrates the cushion that is provided by the strategy, if interest rates were to increase over the holding period. As summarized, a dramatic shift of 150 Bps in the yield curve continues to generate positive or virtual break-even results. Ultimately, interest rates would have to increase by over 150 bps to eliminate the benefit provided by the strategy. Of course, should interest rates decline, investors would experience a corresponding increase in excess return.
Conclusion Fixed income investors concerned with the possibility of rising interest rates and the related principal loss, but also seeking more generous yields than those provided by short term money market instruments, should consider the strategy of “rolling down the yield curve”. The higher yields provide an element of protection, as it can help offset losses from price declines that result from an increase in interest rates. Ultimately, the strategy provides investors with a potentially higher-yielding strategy to navigate through the current low interest rate environment. The RBC Target Maturity Corporate Bond ETFs provide a simple and easy way to effectively execute this strategy with the additional benefits of enhanced liquidity, diversification and flexibility.
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45192 DI (05/2012)
