Riding and Rolling the Yield Curve in Government Securities
An investment strategy that you may want to consider is Riding and Rolling the Yield Curve. Using $1.5 million, for example, purchase $500,000 each of the 4-year, 3-year, and 2-year Treasury Notes. (Or 12-month, 9-month, and 6-month bills; any term structure of maturities is possible.) Each year as the notes age, the 4-year note will become a 3-year note, the 3-year note will become a 2-year note, and the 2-year note will become a 1-year note.
When the 2-year note becomes a 1-year note, it should be sold and a new 4-year note should be bought. A continual roll out of the current 1-year note and back into a new 4-year note should be maintained year after year, for whatever period of time is appropriate. Because there is an active and huge market in government securities, these notes can be easily liquidated. Because of this convenience, this strategy can be maintained indefinitely and liquidated as needed.
Please look at this illustration of typical (not actual) Treasury Note rates:
|4 yr. Note||3 yr. Note||2 yr. Note||1 yr. Note|
The average annual yield of the portfolio for the first year would be 1.50%. Each year (in a normal, steepening yield curve environment) the lowest yielding note would be sold and a new highest yielding note would be purchased. Throughout the life of the investment, average annual yield for the portfolio would remain somewhere around the prevailing 3-year note level.
Assume that rates prevailing in the market were to remain constant. Then, when the 4-year note would have aged to become a 1-year note, its price would have appreciated from par (100) to approximately 101.5. This price appreciation will necessarily occur in order for the note to be a comparable investment to the 0.50% yield that would be the current market yield for the 1-year note. For the 4-year note, this appreciation would represent an approximate +2% capital gain over three years. As the 3-year and 2-year note age (roll down the yield curve) to the point of having a 1-year maturity they, too, would have to experience capital appreciation in order to be comparable to the prevailing 1-year note yield. In addition to these capital gains, the portfolio continuously earns income at approximately the 3-year note rate.
1. If interest rates remain constant, the 1-year note will likely be sold at a gain.
2. If interest rates are declining, the 1-year note will likely be sold at a larger gain.
3. If interest rates are rising, the 1-year note may or may not be sold at a gain, depending upon the magnitude of the interest rate rise. Remember, moving back along the yield curve from a 4-year to a 1-year maturity necessitates pick-up (gain) in the price of the note in order to maintain the appropriate yield spreads between the different maturities. This gain acts as a hedge against the price loss due to rising interest rates.
Importantly, at all times the portfolio is earning an annual interest rate considerably higher than the rate that could be earned on a single, short-term treasury note or bill period. And, if rates rise to the extent that this strategy ceases to be profitable, simply hold the notes until maturity.
Another Option: Use actively traded Government Agency Notes rather than Treasury Notes. This will likely result in a yield pick up for the portfolio with only a slight increase in risk.