Last month we introduced the concept of a yield curve, looking at its various shapes. Part II in our series on the yield curve, explores its purpose and explains what is meant by ‘playing the yield curve’. Further articles in this series will discuss different ways to measure and construct yield curves.
Using a yield curve with different securities
As we explained last month, yield curves are used to illustrate the yields obtained from an investment for specific maturity dates. Examples of these could include:
- Interest paid on deposits.
- Swaps.
- Money market securities of various forms.
- Bonds (including Government, Treasury or Corporate bonds notes and loan stock).
Uses of a yield curve
The yield curve has a number of uses, particularly in relation to valuation. These uses can be identified as:
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Providing a benchmark for valuation.
Most fixed-income securities (e.g. corporate bonds) involve some form of risk. Investors can use the expected yields from a minimal-risk security (e.g. Government bond) as a benchmark for the potential yields they may gain from a riskier security (e.g. corporate bond). In principle, the greater the risk, the greater the yield.
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Identifying when bonds are cheap or expensive.
Bond prices are determined by a number of factors, including the current value of their expected yields. By comparing various interest-rate forecasts, investors can produce different yield curve scenarios and try to identify the various values for each. This will enable them to establish which particular bonds are – according to their assumptions – cheap and thus represent good investment potential.
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Identifying when returns on bonds can be maximised.
Investors can use the shape and any movement in yield curves to identify the optimum time period to invest. This is commonly referred to as ‘playing the yield curve’ or ‘riding the yield curve’.
There are two main ways to attempt to realise above-average yields. Both relate to the spacing of the bonds’ maturities:
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Bullet strategy.
This is where an investor builds a portfolio of securities with maturity dates concentrated at one point on the yield curve (e.g. ten years). This maturity date is not necessarily the same as the time period for which the funds are available for investment. This is usually more successful when the yield curve is steep.
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Barbell strategy.
This is where an investor builds a portfolio of securities with maturity dates set at two extremes on the yield curve (e.g. five and twenty years). This is usually more successful when the yield curve is flat.
Of course other strategies relating to bond investment also exist. Examples include staggered maturities, matched maturities and the ladder strategy. The last is where an investor builds a bond portfolio with comparable investment amounts spread evenly across different maturity dates. However, all these strategies focus on reducing the interest-rate risk, rather than maximising the yield, as exemplified above. The final use for yield curves is more general:
