Roll-Down Return

We love curves. Who doesn’t, right? Curves can be so sexy, especially those titillating bond yield curves that could potentially make us a bunch of money. Those are our favorites. When we sell bonds for a premium before they’ve reached full maturity—right when they’re in the sweet spot of the yield curve—the money we make is called a “roll-down return.” The “return” part refers to the coin we make, and “roll-down” is how we refer to the changes in yield rates as long-term bonds become shorter-term bonds.

We’re gonna go through a quick example here to demonstrate how this all works. Let’s say Bob pays $500 for a 10-year bond with a 5% yield. Four years from now, his 10-year bond will become a six-year bond, and six-year bonds only have a yield of 4.25%. That’s because longer-term bonds are considered more of a risk—they tie up our money for a longer period of time—so they tend to have higher yields. Anywho, there are people out there who would gladly pay a premium for Bob’s four-year-old bond instead of buying a regular old six-year bond. So if Bob sells his bond at the right time, he stands to make a little bit of a profit. Not only will he get the 5% yield from those first four years, but he’ll also get the premium amount that he sold it for. Overall, this’ll net him a greater return than he would’ve gotten had he hung onto it until maturity.

The trick here is to know our bond curve. When we buy a longer-term bond, we should check out its yield numbers and look for the places where they change the most...the fastest. In other words, look for the steepest part of the curve. Those are the sweet spots we mentioned earlier. Does this mean we should automatically sell every single bond right when it hits the steep part of the curve? Eh, “every bond” might be a little strong. As with any investment decision, we should step back and take a look at the whole financial picture, including the state of the economy, interest rates, and, of course, the status of and goals for our own investment portfolio.