Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. This article originally appeared on the CFA Institute’s Inside Investing blog here.
The rapid selloff in the U.S. Treasury market came as a surprise to many, including such famous bond investors as Bill Gross and Jeffrey Gundlach. As the chart below shows, 10-year yields on U.S. Treasury bonds are about 130 basis points higher since the beginning of May.
Retail investors have been rapidly selling out of bond funds. That may be either wise or unwise with the benefit of hindsight, but one often-overlooked fact remains: New and existing bond investors now have the benefit of a much steeper yield curve.
In fact, the “roll-down” portion of a bond’s return is one of the most important and least understood aspects of a bond’s total return.
If we assume that the yield curve is upward sloping, as is currently the case, we can use a simple example to demonstrate a bond’s roll.
First, take a look at this chart. It shows five-year Treasury bonds with a yield of 1.69% and seven-year Treasuries with a yield of 2.31%. An investor who bought a seven-year Treasury would own a bond that yields 2.31% until its maturity.
But after two years, the bond wouldn’t be a seven-year bond. It would be a five-year bond. Because the difference in yield between the seven-year at 2.31% and five-year at 1.69% is 0.62%, the five-year yield can rise 0.62% over two years before exceeding the investor’s yield to maturity (2.31%). Therefore, we can define a bond’s roll as the amount that interest rates can rise over a specified time period before the current yield exceeds an investor’s yield to maturity (YTM).
In other words, assuming that interest rates stay the same, this positive “roll” means that the price of the bond will go up as time passes.
Since the rate selloff, the roll has increased as the yield curve has steepened. The spread between the five- and seven-year Treasury bond was only 43 basis points on 1 May versus 62 basis points in our example above.
Going back to our example, let’s assume two years after purchase that the seven-year Treasury bond rates remain the same as today. Using the horizon-analysis screen below, we enter the current yield on the five-year Treasury of 1.69% (remember, two years have elapsed and rates haven’t moved) and a horizon date two years into the future on September 13, 2015. Under “Return Analysis,” we see an annualized total return of 3.69%. So, in addition to the 2.31% annual yield, the bond has appreciated as it has “rolled down the curve.”
This yield curve is historically steep. The current spread between 2- and 10-year Treasury bonds of 245 basis points is greater than 95% of all observations and is only moderately below the all-time high of approximately 290 basis points, which occurred in early 2011.
The hypotheses for the rapid-rate selloff are multifold. Some believe the economy is improving faster than the Fed is expecting, and thus the Fed will need to hike rates faster than what was being priced into the market. Other participants believe the uncertainty around tapering and the Fed chair selection have caused everyone to simultaneously shed long-duration assets.
Higher rates are now priced into the market to a greater degree than a few months ago, thus creating this increased roll from a steeper curve. The concept of “roll” is very powerful with today’s steep curve. In a time of fear and panic in fixed-income land, attractive opportunities are beginning to open up for investors willing to take advantage and invest out along the yield curve.
David Schawel, CFA, is based in Raleigh Durham NC and works as a fixed-income portfolio manager. His blog is Economic Musings and you can follow him on twitter at @davidschawel.
Read more articles by David Schawel, CFA
