Riding the Yield Curve: What it Means, How it Works

What Is Riding the Yield Curve?

Riding the yield curve is a trading strategy that involves buying a long-term bond and selling it before it matures so as to profit from the declining yield that occurs over the life of a bond. Investors hope to achieve capital gains by employing this strategy.

As a trading strategy, riding the yield curve works best in a stable interest rate environment where interest rates are not increasing. Additionally, the strategy only produces excess gains when longer-term interest rates are higher than shorter-term rates.

How Riding the Yield Curve Works

The yield curve is a graphical illustration of the yields of bonds with various terms to maturities. The graph is plotted with interest rates on the y-axis and increasing time durations on the x-axis. Since short-term bonds typically have lower yields than longer-term bonds, the curve slopes upwards from the bottom left to the right. This term structure of interest rates is referred to as a normal yield curve.

For example, the rate of a one-year bond is lower than the rate of a 20-year bond in times of economic growth. When the term structure reveals an inverted yield curve, this means short-term yields are higher than longer-term yields, implying that investors’ confidence in economic growth is low.

In bond markets, prices rise when yields fall, which is what tends to happen as bonds approach maturity. To take advantage of declining yields that occur over a bond’s life, investors can implement a fixed-income strategy known as riding the yield curve. Riding the yield curve involves buying a bond with a longer term to maturity than the investor's expected holding period in order to produce increased returns.

Advantages of Riding the Yield Curve

An investor’s expected holding period is the length of time an investor plans to hold his investments in his portfolio. According to an investor’s risk profile and time horizon, they may decide to hold a security short-term before selling or to hold long-term (more than a year). Typically, fixed-income investors purchase securities with a maturity equal to their investment horizons and hold to maturity. However, riding the yield curve attempts to outperform this basic and low-risk strategy.

When riding the yield curve, an investor will purchase bonds with maturities longer than the investment horizon and sell them at the end of the investment horizon. This strategy is used in order to profit from the normal upward slope in the yield curve caused by liquidity preferences and from the greater price fluctuations that occur at longer maturities.

In a risk-neutral environment, the expected return of a three-month bond held for three months should equal the expected return of a six-month bond held for three months and then sold at the end of the three-month period. In other words, a portfolio manager or investor with a three-month holding period horizon buys a six-month bond—which has a higher yield than the three-month bond—and then sells the bond at the three-month horizon date.

Special Considerations

Riding the yield curve is only more profitable than the classic buy-and-hold strategy if interest rates stay the same and do not increase. If rates rise, then the return may be less than the yield that results from riding the curve and could even fall below the return of the bond that matches the investor’s investment horizon, thereby, resulting in a capital loss.

In addition, this strategy produces excess returns only when longer-term interest rates are higher than shorter-term rates. The steeper the yield curve's upward slope at the outset, the lower the interest rates when the position is liquidated at the horizon and the higher the return from riding the curve.