Question

Explain the impact of the steepening of the yield curve on two bonds portfolios. Both portfolios have equal Macaulay’s duration. The first portfolio is designed as a bullet (100% allocation to the mid-maturity in the yield curve) and the other as a barbell (allocation split between the short and the long maturities in the yield curve). You must demonstrate your answer with an example.

Explain the bullet and barbell strategy and why investor are indifferent between choosing one or the other when no expectations regarding changes in the terms structure.

Explain the link between yield curve flattening or steepening on the two investment strategies.

Show using an example: create the two portfolios and ensure durations are matched.

Explain how when yield curve flattens/steepens the effect on the two strategies.

Answer 1

The impact of the steepening of the yield curve on two bonds portfolios- An yield curve represents the plotting of bond's yield along with its maturity. When the yield curve steepens, the difference between long term and shor tern rates increases. It means that there is widening of the difference between short term and long term yields. A bullet strategy go well with the steepening of yield curve.

Example-investors or market expecting rising inflation and higher economic growth.

A barbell strategy do well at the time of flattening of the yield curve. In this strategy only short tem and long term bonds are purchased. The first portfolio which is designed as bullet would likely outperform the barbell in the case of steepening yield curve. Both portfolios have equal Macaulay's duration which provides an estimate of the percentage change for a bond in yield to maturity. It is a weighted average of time to receive the bond's cash flows.

A bullet strategy is used in the case of steepening yield curve, in this strategy bonds invested at different times that all mature at the same date due to which investors can receive a more attractive inflow, as a bullet portfolio holds securities targeting a single segment of the curve, with the bomds clustered around the portfolio duration target whereas a barbell strategy is used in the case of flattening yield curve, as a barbell portfolio combines securities with short and long maturities compared with the duration target. In this strategy sets of bonds mature in the long term and short term but not in the mid term.

There is more risk with the barbell portfolios rather than bullet portfolios. Barbell portfolios have greater convexity than bullets. Convexity is the weighted average square of time to maturity.