Bond yields fall as curve shifts downward
Yield curve rolldown is a capital gain investors capture as a bond’s maturity shortens and it moves to a lower-yielding point on the yield curve.
This assumes an upwardly sloping yield curve, and the steeper the curve, the more rolldown one captures.
A recent analysis pulled in over 20 years of government bond data, sliced it into maturity buckets, and analyzed which buckets produced the greatest returns from rolldown over those 20 years.
The best performing bucket in Gilts and Treasuries was the 3-4yr, while in Bunds the 4-5yr bucket performed best.
These short end buckets may have benefited from the greatest rolldown, but in a secular falling yield environment, they delivered lower total returns than the broader index and their longer-dated peers.
This is due to being shorter duration.
Related: Inflation fears risk tipping into deflation
When we looked at the risk-adjusted returns, things start to look more interesting.
The historic Sharpe Ratios of the lower duration buckets are meaningfully higher than the competition.
The table summarizing the results shows that once the volatility of returns is considered, the short-dated buckets show their value to an investor.
This is because they provide a higher return per unit of volatility.
So bond investors can exploit these results by buying more front-end bonds to improve the risk-return characteristics of their portfolio.
However, this would reduce the duration of their wider portfolio and leave them at risk of underperforming if yields were to fall over the next 20 years.
Related: SpaceX asteroid threatens telco and cable giants
Another approach is to overweight the short-dated bucket and underweight the longer bucket, while maintaining a neutral duration across the portfolio.
This approach more or less matches, if not beats, the performance of the overall index and reduces the volatility meaningfully.
The strength of outperformance clearly varies across £, €, and $s, but in all cases, having an overweight to the front end/steepest part of the yield curve generates better risk-adjusted returns.
Rolldown can contribute meaningfully to a bond investor’s performance, and harvesting this can assist in beating passive exposure to fixed income markets.
According to the report, the analysis used 20 years of government bond data to determine the best performing buckets.
The results show that the 3-4yr bucket in Gilts and Treasuries, and the 4-5yr bucket in Bunds, produced the greatest returns from rolldown.
