Introduction to Yield Curves – (2)

For example, as at January 31, 2017, the 15.54% 13-FEB-2020 FGN Bond with a term-to-maturity of 3.04 years had an average yield of 16.36%. In comparison, State Government and Corporate Bonds with similar maturity profiles had average yields of 17.42% – 19.44%, and 18.75% – 20.44% respectively. The yield spread (difference in the yield on two (2) securities of similar characteristics) reflects the credit risk premiums investors attach to the two (2) categories of securities on issue.

For illustration purposes, we examine three (3) categories of bonds listed on Exchange XYZ as follows: “AAA” rated Federal Government Bonds (“Govt. AAA”) and Corporate Bonds of “AAA” (“Corp. AAA”) and “AA” (“Corp. AA”) ratings, all with similar maturities of between one (1) month to thirty (30) years.

The respective yield curves and spreads are presented in the chart and table below.

The chart shows that the curve for “Govt. AAA”, which will typically be of a low-risk profile, lies below the “Corp. AAA” and “Corp. AA”, serving as a reference yield.

Similarly, the yield spread across the three (3) bond categories, as can be seen from the Yield Curve Comparison Table below, shows the risk premium investors demand as compensation for investing in the “riskier” Corporate Bonds i.e. “Corp. AAA” and “Corp. AA”. This implies that, for instance, investors demand a 4.00% (or 400 basis point) premium over an AAA-rated 30-year Federal Government Bond to invest in an AA-rated 30-year Corporate Bond.

The yield curve can, therefore, be seen to offer a unique tool for extracting the “relative value” of a fixed income security through comparison with another “benchmark” security of similar maturity. Investors can compare the yield curve of an AAA-rated Federal Government Bond, for example, with that of an AA-rated Corporate or Municipal Bond to determine their probable yield (known as yield spread) should they assume some credit risk.

Similarly, the yield spread can also be evaluated from a “current yield vs historical yield” perspective for the same fixed income instrument, as a way of estimating the relative attractiveness of the security. The yield curve could also be used to compare the yield across different maturities within the same fixed income classification, such as the yield spread between a 2- and 10-year Corporate Bond.

Portfolio Management Strategy: Fixed income portfolio managers often benchmark the performance of the assets in their portfolios against expected movements in the yield curve, in order to boost returns across diverse interest rate scenarios.

In this regard, three (3) yield curve strategies (bullet, barrel and ladder) are often referred. In a bullet strategy, the maturities of all the securities in the portfolio are concentrated at a point on the yield curve [say ten (10) years], while the barrel strategy concentrates the maturities of the securities in a portfolio at two (2) extreme points on the yield curve [say five (5) and twenty (20) years]. The ladder strategy, on the other hand, involves the allocation of the same amount of securities across various maturities such that a given amount matures periodically

Other yield curve strategies which are employed by fixed income portfolio managers include: “riding the yield curve”, or “playing the yield curve” in which bond investments, for instance, are made at calculated terms to maturity such that as each bond approaches maturity, it is valued at a successively lower yield, and hence higher prices.

In summary, the yield curve lends itself as a useful tool in investment analysis; providing a clue on the future macroeconomic direction (forecasting a recession or an economic boom), as well as being an important valuation tool for portfolio managers. Yield curves tell a unique story which investment professionals explore to optimise returns in the fixed income market, and a skillful analysis of the slope of the yield curve facilitates investment decision across short-, medium- and long-tenored fixed income securities.

The third (and final) part of this “Introduction to Yield Curves” series will explore the Nigerian Sovereign Yield Curve, exploring its shape and uses in the Nigerian fixed income market.