Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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Peculiar_Investor
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Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by Peculiar_Investor »

A recent high level discussion of Rolling Down The Yield Curve Strategy, as well as previous discussions championed by adrian2, have gotten me thinking about whether the individual investor who constructs and operates a bond ladder could actually implement and benefit from this strategy.

While I understand the overall strategy, the individual investing doesn't have much pricing setting power when buying/selling bonds and the bid/ask spread tends to be more than just pennies on the dollar. Clearly for bond ETF managers they have pricing power so the strategy make sense to implement.

Has anyone on FWF analyzed this strategy and actually implemented it with their own bond ladder? I've got three different bond rungs maturing in 2018 and have just started doing the math on whether the actual implementation of selling these bonds now and re-deploying the funds into rungs at the far end would match the theoretical benefit. From a quick look at TD DI, I'm not overly enthusiastic about the prices being offered on my upcoming maturities and wonder if I'm giving up too much on the bid/ask to make rolling down the yield curve cost effective.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by Peculiar_Investor »

Decided to take the plunge and give it a try.

In a registered account I had BRP Finance Corp 5.25% coupon bond maturing 11/05/18 with a current YTM of 2.37% at TD DI's bid price. I could replace it with the same issuer, BRP Finance Corp, a 3.63% coupon bond maturing 01/15/27 with a YTM of 3.73% at TD DI's ask price. Rolling down the yield curve picks up 1.36% by my calculation. Per TD DI's disclosure on the sell/buy, I gave them ~$100 of 'Dealer Firm remuneration' plus some vig on the bid/ask spreads, which is obviously the downside to this strategy for the individual investor.

In the context of the whole bond ladder, the average years to maturity went from 4.82 years to 5.04 years and the YTM went from 3.12% to 3.17%. The additional benefit is the 2027 rung on the bond ladder is filled.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by AltaRed »

Thank you for sharing. I've seen this discussed in other forums as well and if one is willing to put in the effort, I believe some dollars can be made. For me, it comes down to use of my time and I am too lazy to do that myself.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by ockham »

I played with this idea briefly some 15 years ago -- trying to trade bonds around the "sweet spot" on the yield curve, where "sweet spot" is defined as the steepest part of the yield curve. Soon gave up. The sweet spot moves, disappears, reappears elsewhere. Bond trading is expensive, and bond pricing opaque. I now numbly, dumbly buy a rung at 8-9 years, and hold to maturity. Rip Van Winkle investing (on the fixed income side, at least).
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by Peculiar_Investor »

ockham wrote: 09 Jan 2018 13:05 trying to trade bonds around the "sweet spot" on the yield curve, where "sweet spot" is defined as the steepest part of the yield curve.
I'm not going there. I'm just trying to determine whether or not to include this process into managing my existing bond ladder. By definition we will have bonds maturing periodically, so a reinvestment decision is required. At this point I just see this as changing when that decision has to be made and adding a bit of extra work. There are professionals that do this for a living, I'm not trying to predict the future, compete or out-guess them. Just keeping it simple but at the same time possible gaining an advantage for a small amount of work.
AltaRed wrote: 09 Jan 2018 12:05 I believe some dollars can be made. For me, it comes down to use of my time and I am too lazy to do that myself.
At this point it is partially an intellectual exercise, less about making some dollars and more about actually doing something that theory suggests would benefit me. I learn theory best when I actually practice it to understand the nuances and assumptions involved. Given that most rungs on our bond ladder consist of between two and four issuers/maturities, it really isn't a time consuming activity and it keeps the grey matter engaged.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by IdOp »

I believe the "rolling down" benefit assumes the yield when you sell the bond is less than when you bought it, for a simple example if the yield curve is normal (not inverted) and static (doesn't change). But if interest rates are rising, as they may (or may not) from here, this would reduce or even eliminate the expected benefit.
Last edited by IdOp on 09 Jan 2018 23:08, edited 1 time in total.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by Peculiar_Investor »

Further reviewing my bond portfolio spreadsheet, the BRP Finance 11/05/18 bond that I sold was purchased in July 2010 at $100.59 and sold at $102.32, so I've also locked in some capital gains with a total return around 41% (according to the spreadsheet).

I have two other 2018 maturities, one of which also could be sold to realize some capital gains as well as benefiting from an interest rate pickup. The analysis, and learning, continues.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by ockham »

Isn't this where the bond guys at PHN or at Mawer get to earn their keep?
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by Peculiar_Investor »

ockham wrote: 09 Jan 2018 21:38 Isn't this where the bond guys at PHN or at Mawer get to earn their keep?
Probably, although given the trade sizes involved it probably all remains within the discount brokerage.

Just channeling my inner Walter Mitty. It is probably the same as trading preferred shares knowing the other side is probably James Hymas. :lol:

I learn by doing and I've previously posted my rationale for moving away from using a broad-based index fund or ETF for my fixed income asset allocation as we've gotten within range to possibly see the retirement line for my spouse. This is part of the overall learning experience.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by Shakespeare »

I'm now little interested (as it were) in even keeping a bond ladder running; my next GIC maturation next month will zig into ZAG. Simplify, simplify. :wink:
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by jiHymas »

The effect exists of course - in a normal yield curve, anyway! - but I don't see how turning these expectations into a central part of bond management strategy can possibly be a good idea.

Such a strategy involves making a sell decision based on what the bond's yield was a year ago - or whatever roll-down period has been chosen. Why?

I have more sympathy for:
ockham wrote:I played with this idea briefly some 15 years ago -- trying to trade bonds around the "sweet spot" on the yield curve, where "sweet spot" is defined as the steepest part of the yield curve.
This is an entirely rational strategy, but can only be implemented sensibly as one component of a more complex system. Greydanus, Boeckh & Associates: The Yield Curve Kink Decision used to be free, but a quick googling has found only copies for sale; but the central idea is easily explained.

Consider two bonds, one with a ten-year term, the other with ten-and-a-half years to go. They both have 5% coupons and are evaluated on their coupon date, so trade with no accrued interest. The former trades with a yield of 5% and hence is priced at par. The latter trades to yield 5.18% and is therefore priced at 98.56, a discount from par of 1.44.

But this is craziness. The cash flows for the two bonds are identical up until the time that the first bond matures. Why are we valuing the same cash flow from the same issuer on the same date at two different rates? The answer, of course, is because we're lazy, stupid stockbrokers who work for a bank. If instead we value all the cash flows up to the end of year 10 at the same value, we get the Present Value of the first twenty coupons from the second bond to total 38.97. This implies that the Present Value of the final payment, Future Value 102.50, has a Present Value of 59.59, which implies a Discounting Factor of 0.581366, which implies a yield-with-semi-annual-compounding of 5.23%.

That's a significant jump, from 5% on the penultimate payment to nearly 5.25% on the last one. For a mere six-months of extra term-risk! That's worth looking at more carefully to see if I can sell the ten-year I hold to buy the ten-and-a-half year I don't; maybe I can lay off the term risk by taking action elsewhere in the portfolio.

This is a very simplified example, of course (mainly, it assumes that all cash flows with a term of ten years or less are trading to yield 5%, compounded semi-annually), but you get the idea: Curves Are Cuter When They're Kinky!
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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My fixed income strategy is to ladder corporate bonds . RBC AD allows me to screen based on YTM. It is troubling in the rising interest rates market to see an overall decline in the value of my bonds. My strategy is to hold to maturity unless I see concerns over the credit quality of the issuer. I have basically ignored the noise about paper losses on my bonds. I have always believed that I receive the YTM yield and the principle amount upon maturity. It should be similar to buying a GIC? Curious what others have to say. I think I am right but that doesn't mean I am right. I might be wrong in assuming that the RBC YTM figures are accurate? Thank you for your insights.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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Thegipper wrote: 12 Mar 2018 09:04 My fixed income strategy is to ladder corporate bonds . RBC AD allows me to screen based on YTM. It is troubling in the rising interest rates market to see an overall decline in the value of my bonds. My strategy is to hold to maturity unless I see concerns over the credit quality of the issuer. I have basically ignored the noise about paper losses on my bonds. I have always believed that I receive the YTM yield and the principle amount upon maturity. It should be similar to buying a GIC? Curious what others have to say. I think I am right but that doesn't mean I am right. I might be wrong in assuming that the RBC YTM figures are accurate? Thank you for your insights.
i agree with you. in my simplistic view if i buy a bond for X and the YTM is Y and X+Y = total return. if i'm getting my target total return i don't mind too much if it's made up of any combination of price or yield. i mean the coupon is fixed right? the only thing that fluctuates is the price but in the end bonds are redeemed at par and that what is used to calculate YTM?
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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rharvey199 wrote: 12 Mar 2018 09:54
Thegipper wrote: 12 Mar 2018 09:04 My fixed income strategy is to ladder corporate bonds . RBC AD allows me to screen based on YTM. It is troubling in the rising interest rates market to see an overall decline in the value of my bonds. My strategy is to hold to maturity unless I see concerns over the credit quality of the issuer. I have basically ignored the noise about paper losses on my bonds. I have always believed that I receive the YTM yield and the principle amount upon maturity. It should be similar to buying a GIC? Curious what others have to say. I think I am right but that doesn't mean I am right. I might be wrong in assuming that the RBC YTM figures are accurate? Thank you for your insights.
i agree with you. in my simplistic view if i buy a bond for X and the YTM is Y and X+Y = total return. if i'm getting my target total return i don't mind too much if it's made up of any combination of price or yield. i mean the coupon is fixed right? the only thing that fluctuates is the price but in the end bonds are redeemed at par and that what is used to calculate YTM?
I have been laddering bonds for 18 years and I figure it has worked. My goal is safety with a yield that beats the inflation rate and gives some extra. My current portfolio is laddered to 2027 and I figure the yield to maturity is about 4%. As I roll over maturing bonds I participate in the new higher yields[ in a rising interest rate market]. I would be very reluctant to buy a bond fund or ETF in a rising interest rate scenario. It think it is guaranteed to deliver negative returns. I have nothing against GIC except for one aspect. You can't sell or trade a GIC.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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I have nothing against GIC except for one aspect. You can't sell or trade a GIC.
Why would anyone want to, some are assignable transferable you can borrow against it etc..
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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rharvey199 wrote: 12 Mar 2018 09:54in my simplistic view if i buy a bond for X and the YTM is Y and X+Y = total return. if i'm getting my target total return i don't mind too much if it's made up of any combination of price or yield. i mean the coupon is fixed right? the only thing that fluctuates is the price but in the end bonds are redeemed at par and that what is used to calculate YTM?
In the first sentence there's a misconception ( I'm not sure if it's too simplistic or too complicated :wink: ). A bond's YTM takes into account both the coupon and price changes, and in that sense is similar to a total return already, so no need to add X to Y. In more detail, YTM results from a discounted cash flow equation, just like IRR does. The only difference between the two is how the resulting returns are parametrized. YTM is usually given as a semi-annual yield, say y, while IRR is an ordinary annual return, say r. The relation between the two is ( 1 + y/2 )2 = 1 + r .
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

Post by AltaRed »

To finish off IdOp's thought, YTM does assume price is redeemed at maturity at par.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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BRIAN5000 wrote: 12 Mar 2018 17:52
I have nothing against GIC except for one aspect. You can't sell or trade a GIC.
Why would anyone want to, some are assignable transferable you can borrow against it etc..
In the event of death or a special circumstance were you might need to cash it in. I guess borrowing is one option.
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Re: Bonds - Rolling Down The Yield Curve, theory vs real-life experience

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IdOp wrote: 12 Mar 2018 22:15
rharvey199 wrote: 12 Mar 2018 09:54in my simplistic view if i buy a bond for X and the YTM is Y and X+Y = total return. if i'm getting my target total return i don't mind too much if it's made up of any combination of price or yield. i mean the coupon is fixed right? the only thing that fluctuates is the price but in the end bonds are redeemed at par and that what is used to calculate YTM?
In the first sentence there's a misconception ( I'm not sure if it's too simplistic or too complicated :wink: ). A bond's YTM takes into account both the coupon and price changes, and in that sense is similar to a total return already, so no need to add X to Y. In more detail, YTM results from a discounted cash flow equation, just like IRR does. The only difference between the two is how the resulting returns are parametrized. YTM is usually given as a semi-annual yield, say y, while IRR is an ordinary annual return, say r. The relation between the two is ( 1 + y/2 )2 = 1 + r .
yes YTM already factors in the price of the bond. i guess i meant i look at things from a total return point of view. if whatever combination of price and yield gets me to me target total return i'm good. :)
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