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Riding the Yield Curve

Reviewed by Bhavana | Updated on Oct 05, 2020


Introduction to Riding The Yield Curve

It is a trading strategy which includes buying and selling of a long-term bond before it matures in order to benefit from the declining yield which occurs over the life of a bond. Investors expect to generate capital gains with the use of this strategy.

As a trading technique, the yield curve performs best in a stable interest-rate setting where interest rates do not rise. In addition, the strategy only produces excess gains if the longer-term interest rate is higher than the shorter-term rate.

## How Does it Function?

The yield curve is a pictorial representation of the yields of bonds with different periods to maturities. The graph shows interest rates on the y-axis and raising time durations on the x-axis. As short-term bonds usually have lower yields than longer-term bonds, the curve slopes up from the bottom left to the top. This term interest rate structure is referred to as the normal yield curve.

In bond markets, prices rise as yields drop, which is what probably happens as bonds approach maturity. To take advantage of declining returns that occur over the life of a bond, investors can implement a fixed-income strategy known as the yield curve.

Riding the yield curve involves buying a bond with a longer-term maturity than the investor's expected holding period in order to generate increased returns.

## What are the Benefits of Riding the Yield Curve?

The expected holding period of the investor is the length of time that the investor plans to hold his investments in his portfolio. Based on the time horizon as well as the risk profile of the investor, they may decide to hold short-term security before selling or to hold long-term security (for more than a year).

Typically, investors with fixed incomes purchase securities with a maturity equal to their investment horizons and hold them to maturity. But riding the yield curve tries to outperform this basic and low-risk strategy.

When riding the yield curve, an investor purchases bonds with maturities longer than the investment horizon and sells them at the end of the investment horizon. This strategy is used to benefit from the usual upward trend in the yield curve induced by liquidity preferences and higher price volatility that arise at longer maturities.

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