Yield Curve Dynamics

Book By Ronald J Ryan

Article and Review by GlobalMacroForex

Although this book was written in 1997 after a huge bull run in bonds and before the 2007 financial crisis, it still provides a lot of useful information.  The book is a collection of different authors’ insights into the bond market.  Primarily it gives the reader better methods and tools to evaluate bonds and make decisions.

The duration of a bond is how sensitive it is to changes in interest rates.  It’s also a measurement of how soon (in time) an investor gets his (or her) initial investment back in coupons.  There are a few different types of duration but external factors change the duration in predictable ways.  This book lays out simple rules:

Rule 1) The longer the time to maturity, the greater the change in price, given a set change in yield

This is easy to understand.  So if you have two bonds, with the first bond maturing in 1 year and the second bond maturing in 30 years.   The second bond (30 years) will change in price more rapidly since it has more time paying coupons at the new interest rate.

Rule 2) The higher the coupon, the lower the price/yield sensitivity of the security

Remember that duration is a measurement of the time until an investor receives his money back on the bond.  The higher the coupon the sooner the investor gets back the original investment.

Rule 3)  The higher the yield to maturity (YTM), the lower the price/yield sensitivity of the issue

For example, Bond A has 11 percent Yield to Maturity which changes to 10 percent.

11% – 10% = 1% change in Yield to Maturity

Bond B goes from 5% to 4%: So 5% – 4% = 1%

Both bonds changed 1% in Yield to Maturity.  However, 1% is ¼ of 4%, but the only 1/10th of 10%.  So the larger Yielding Maturity changes less.

Yield Curve Spread Bets

Another aspect of this book is devoted to spread trading along the yield curve.  Under this strategy, the investor seeks to profit from an unusually large spread between two bonds on the yield curve.

To implement the strategy, the investor goes long the higher-yielding bond and shorts the lower yielding bond.  This neutralizes the effect of an increase or decrease in rates across all maturities  (aka “Parallel yield curve shift”).

To evaluate if the spread is unusual, this book advocates the following formula:

(Yield of Bond going long) – (Yield of bond going to short) / Standard Deviation of Spread

This formula (which assumes rates have the same probability of going either way) evaluates the risk of this trade (Standard Deviation of the Spread) compared with how much reward (Spread) one gets.

Bond Ladder Strategy

Yield to maturity is the yield using current purchase price plus coupons and face value principle, but yield to maturity assumes cash flows from the security will be reinvested at the same rate of return.  This book introduces the concept of ‘true yield,’ which is the actual yield after taking into account reinvestment risk.

A bond ladder strategy is a concept of buying bonds of varying maturity lengths so that this way if interest rates rise, only part of the portfolio is exposed to the reinvestment risk.  Then the investor would reinvest the maturing short-term bonds at the end of the time ladder.  This graphic from Fidelity helps to visualize this,

The authors of this book warn against ladder strategies because of the reinvestment risk.  However, they focus on reinvestment risk so much because in 1997 they had a huge bull run in bonds.  Today the central banks have nearly bottomed out interest rates with negative rates in Japan and Switzerland.  So it’s much more possible that interest rates will rise, and therefore I disagree with the author that a bond ladder is very risky due to reinvestment risk.  Rates are so low now that an investor wouldn’t even want to lock these rates in.