We have discussed the concepts related to the yield curve in the Jargon Buster on yield curves. Yield curve represents the yield spreads that arise due to the differing maturities of fixed income instruments. It depicts the relationship between the fixed income instrument interest rates and maturities. Yield curve helps a fund manager to forecast the interest rate movements and the economic activity and accordingly invest in fixed income instruments. However, there is another phenomenon called 'Rolling down the yield curve' which can be capitalized on by the fund managers to earn an incremental return from the same fixed income instruments.

Rolling down the yield curve is essentially an active fund management strategy employed by various fund managers to give that extra boost to the returns generated by the vanilla fixed income instruments.

There is no rocket science involved but it does take the time and efforts of a fund manager to ensure that the rollover yield generated is worth the shot at this strategy. In a fixed-income portfolio which is employing the "rolling down the yield curve" strategy, reading the yield curve is one of the most crucial determinants of the performance of the fund. Basically, changes in the yield curve will have an effect on the fixed income portfolio returns.

The yield curve changes are typically expressed in terms of "shifts", "twists" and "butterflies". Shifts in the yield curve refer to parallel shifts either upwards or downwards. Twists in the yield curve relates to whether the yield curve has steepened or flattened. Butterfly can be negative or positive depending on the curvature of the shift.

Now we come back to the core area of discussion on how to roll down the yield curve. Rolling down the yield curve takes advantage of the yield curve when it is at its highest point. A fund manager will buy a bond when it is at the highest point of the steepening yield curve and continue to hold it until its yield curve reaches a lower yield yielding point. And at this point the fund manager shifts to another bond where the yield curve of that bond is at one of the highest points when that yield curve is steepening, and so on and so forth. This is known as"rolling down the yield curve".

Still sounds confusing? Let us understand the phenomenon of rolling down the yield curve with an example. Suppose the annualized yields of 2 and 4 year G-Secs are 7 and 8 % respectively. The par value of both G-Secs is 100. We assume these figures for simplicity. If an investor buys a 4 year G-sec, he will receive the par value of 100 on maturity and the annualized coupons at 8%. Now let us assume that the yield curve does not change for the next two years. After holding the G-sec for 2 years, the instrument has two years to maturity and is as good as a 2 year g-sec with a coupon of 8%, but now trading at a yield of 7% - which is the yield at which 2 year G-secs are currently trading. If the investor sells this G-sec now, he will receive a price appreciation on his instrument (as it is trading at a yield of 7%) and two year annualized coupons at 8%. The investor can now again reinvest the proceeds in a four year G-sec to get a coupon of 8% and repeat the same process to earn price appreciation as well as the annualized coupons. Thus, in such a case, the investor earns returns much higher than he would have earned had he held the treasury to maturity to collect proceeds at maturity of 100 and coupons at 8%.

Active fund managers can use this strategy to add value to their client's portfolio's and earn them extra returns by way of capital appreciation. However, this would be feasible only when the yield curve is normal or upward sloping. The bond is sold before maturity when it is valued at lower yields and hence higher prices. This enables the fund manager to capture both the increase in price of bond which is currently trading at a lower yield and which was bought when it was trading at a higher yield with high coupons.

As explained, the obvious advantage in this strategy is that the fund manager or investor enjoys holding the bond when it is giving the best return in its yield curve.

This strategy can be enhanced if it is done with relatively shorter term bonds. This is due to the inverse relation between duration (interest rate risk) and the number of years to maturity. If we use short term bonds, the maturity will be less and so the risk due to changes in the interest rates. So even if the interest rates move up, the decline in the price will be less pronounced than that of the longer term bond.

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