Pimco's Tony Crescenzi says financial advisors may want to use a strategy called "rolling down the yield curve" with older clients that can protect bond principal when interest rates rise and capture higher total returns.
Rolling down the yield curve is a strategy that recognizes that a bond's yield drops and its price goes up as its maturity becomes shorter. An investor's total return can go up by selling the bond and capturing the gain. The steeper the yield curve, the higher the returns.
It makes sense to use the strategy with intermediate-term Treasury bonds because they have shorter durations and are less prone to the volatility and price movement that might occur from changes in market interest rates, says Crescenzi, an executive vice president, market strategist and portfolio manager at Pimco.
Crescenzi provided this example to illustrate the strategy:
"The aging by one year of a seven-year maturity that matures in 2019 causes it to roll down to a yield that approximates a six-year maturity. For example, if today a seven-year yields 1.6% and a six-year yields 30 basis points less than that, or 1.3%, a year from now the seven-year will be a six-year and therefore the stated yield on that bond will decline by 30 basis points, which can add a percentage point to the total return at the current rate. In this climate a percentage point is a big deal because interest rates are extremely low. If the investor that bought the seven-year sells it, he or she will capture the price gain, increasing not its yield but the total return of the investment, which includes the interest earned and price gain of a percentage point, for a total return of 2.6%."
"Many retirees are dependent on interest income and this is one way to counter the low interest rate environment," says Crescenzi, who spoke about the bond strategy during Envestnet's market outlook phone conference last month. The conference included predictions from Blackrock's Bob Doll and Lord Abbett's Milton Ezrati.
"The predictability of the yield curve depends on steady interest rates," says Crescenzi.
He noted the curve has been steep or positively sloped since 2007, according to Fed Reserve interest rate data.
Members of the policy-setting Federal Open Market Committee announced recently that interest rates will stay low through 2014. "Their decision to extend will create greater confidence in rolling down the curve. What makes rolling down the curve attractive now is the certainty regarding the Federal Reserve and its interest rate policy," says Crescenzi.
"The normal state of the yield curve is when yields on longer maturities are higher than that of shorter maturities. Yields on longer maturities are higher than those of shorter maturities because there's more uncertainty about the long-run trend in inflation, growth, and monetary policy. Roll down only works in a steep yield environment," says Crescenzi.
-Juliette Fairley