Earlier in the year there was a large consensus on yield curve positioning – with inflation fears and the 10 year rising off historic lows, the predominant call was to reduce duration. However, it is important to consider the shape of the yield curve, and not just an overall duration number. There are numerous ways at getting to a specific duration – for example, if the desired duration is 2 years, you can invest in a bond with a duration of 2 years, or take a barbell approach consisting of some shorter duration bonds and some longer duration ones. Positioning a bond portfolio to optimize roll-down return can lead to more desirable investment results.

Roll-down return is the part of total return due to the passage of time. Given an upward sloping yield curve, shorter maturities have lower yields than longer maturities. Therefore, assuming the yield curve doesn’t change over the year, a bond purchased with 3-years until maturity will have a lower yield one year after being purchased. A bond trading at a discount will see an increase in price as its yield declines – this is roll return. 

 

Upward Sloping US Treasury Yield Curve

Source: Bloomberg 8/13/2021

 

Roll-down can play an important role in a bond portfolio and as one would expect, its impact is most measurable in a steep yield curve environment.  Given recent actions of central banks in response to the coronavirus, yield curves are relatively steep.  In the United States, the front-end of the US Treasury curve remains well anchored by Fed policy while the intermediate-to-longer maturities tend to reflect expectations for growth and inflation.  The steepest parts of both US treasury and credit curves today are in the “belly” or 5-10 year maturities, as shown in the below chart.

 

Steepest Part of the Yield Curve is Found in 5-10 Year Maturities

Source: Bloomberg 8/13/2021. BBBs represented by the Bloomberg BVAL curve.

 

Because of this dynamic, the slope of today’s yield curve offers attractive roll-down potential in portfolios.   The chart below shows that the 7-10 year part of the US Treasury curve, by way of an example, produces up to 28 basis points (bps) of carry and roll-down potential (15 bps of carry and 13 bps of roll-down). Carry is the portion of return that comes from a bond’s coupon, whereas roll-down is capital appreciation due to the passage of time.

Source: Bloomberg 8/13/2021.

 

To take advantage of this dynamic we are positioning portfolios with an overweight to the intermediate part of the curve.  To accomplish this, we focus on attractively priced spread product whose characteristics are bulleted in nature.  This is in contrast to amortizing securities such as mortgage pass-through securities that do not benefit from roll-down. 

Generally speaking, yield curves tend to be positively sloped during the early expansionary periods of an economic recovery as the markets price in optimistic projections for growth.  At the same time, we know that yield curves are not static and will shift as expectations for growth, inflation and monetary policy changes.  For this reason investors need to be sufficiently balanced in their approach and not be locked-into a specific positioning.  Over time we have found that in “normal” healthy environments the front-end and intermediate parts of the curve have provided attractive roll-down opportunities and for this reason, we have traditionally incorporated it into our portfolio positioning.

As many markets are looking expensive owning the broader index or even a sector specific fund might not be the best approach.  Security selection has become extremely important in today’s low yield and tight spread environment. Therefore, we believe choosing a fund with the flexibility to own the best opportunities in multiple markets may lead to a better investment experience.

About Risk

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

1 basis point is 1/100 of a percent. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. The US Treasury yield curve is constructed daily using Bloomberg’s valuation service. The curve is populated with USD denominated senior unsecured fixed rate bonds issued by US companies with a Bloomberg composite rating of BBB+, BBB, or BBB. Issuer is the borrower, coupon is stated interest payment, maturity is when the repayment of principal is scheduled to occur, yield is a bond’s IRR, carry represents return from income, and roll represents return from price appreciation. Spread product are bonds that provide incremental yield over a treasury. Front-end refers to shorter maturities and intermediate refers to more intermediate maturities.

Ratings apply to the underlying portfolio of debt securities held by the Fund and are rated by an independent rating agency, such as Standard and Poor's or Moody's. If ratings are provided by the rating agencies, but differ, the higher rating will be utilized. If only one rating is provided, the available rating will be utilized. Securities that are unrated by the rating agencies are reflected as such in the breakdown. Unrated securities do not necessarily indicate low quality. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade.

MacKay Shields is 100% owned by NYLIM Holdings, which is wholly owned by New York Life Insurance Company.

“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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