It’s important to have a strong defensive aspect in any game. Just ask the San Francisco 49ers, whose defense ranked second in the league this year. It’s also critical to find ways to play defense in your portfolio. Once upon a time, the bond roll down provided just that. The roll down allows buy-and-hold investors to generate gains beyond just the coupon on their bonds. Under a normal (that is, upward-sloping) yield curve, as longer bonds age, they are discounted using a lower rate as they come down the yield curve. For example, assuming the yield curve doesn’t change, a 20-year bond yielding 4% might be discounted at, say, a 3.5% rate 5 years later, generating a healthy capital gain for the long-bond investor. This component of the total return provides investors with an essential defense against rising rates, considerably improving the risk/reward profile of long bonds.
Sounds like a pretty sweet deal for those looking to invest in the long part of the curve. The thing is, that advantage exists only if the yield curve is positively sloped. And there’s the rub. In today’s environment, where the 30-year yields a mere 4 bps over the 2 year, that advantage is virtually eliminated. For example, in 2015, even with rates having risen 60 basis points, owning a 20-year bond or a 10-year would have generated very similar total returns on a 5-year horizon – the former would’ve been hurt by its longer duration in a rising yield environment, but was compensated by the higher coupon and roll down. Today, long-term bonds don’t have the advantage of either a high coupon or a significant rolldown, so under a similar rate rise, they would vastly underperform shorter bonds. That’s a large driver of our current underweight in that part of the curve; we believe that strong defense wins game. Of course, the Kansas City Chiefs might disagree.
Vice President and Portfolio Manager
Active and Strategic Fixed Income Team
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