Level III

Yield Curve Strategies

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Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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Contents and Introduction

1. Introduction
2. Foundational Concepts for Active Management of Yield Curve Strategies
3. Major Types of Yield Curve Strategies
4. Formulating a Portfolio Positioning Strategy Given a Market View
5. Comparing the Performance of Various Duration-Neutral Portfolios in Multiple
Curve Environments
6. A Framework for Evaluating Yield Curve Trades

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2. Foundational Concepts for Active Management of Yield
Curve Strategies
Multiple forms of the yield curve

Some assumptions are made to construct

the yield curve

Challenges:
• Gaps in maturities that require
interpolation and/or smoothing
• Observations that seem inconsistent
with neighboring values
• Differences in accounting or regulatory
treatment of certain bonds

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Yield Curve Movements and Slope
• Yield levels have fallen to all time lows
• Yield curve movements can be represented as changes in 1) level 2) slope and 3) curvature
• Yield curve slope = spread between yield on long maturity bonds and short maturity bonds
• Yield curve curvature is measured using the butterfly spread
• Butterfly spread = – short-term yield + 2 medium-term yield – long-term yield

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Duration and Convexity

• Macaulay duration
• Modified duration
• Effective duration
• Key rate duration
• Money duration
• Price value of a basis point

• Effective convexity

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3 Major Types of Yield Curve Strategies
1. Active strategies under assumption of a stable yield curve
• Buy and hold
• Roll down/ride the yield curve
• Sell convexity
• The carry trade
2. Active strategies for yield curve movement of level, slope, and curvature
• Duration management
• Buy convexity
• Bullet and barbell structures

The application of these strategies depends on:

• The investment mandate
• The investment guidelines
• The investment manager’s expectations
• The costs of being wrong

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3.1 Strategies under Assumptions of a Stable Yield Curve
• Buy and Hold

• Riding the Yield Curve

• Sell Convexity

• Carry Trade

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3.2 Strategies for Changes in Market Level, Slope, or Curvature

• Duration Management

• Buy Convexity

• Bullet and Barbell Structures

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Duration Management (1/2)
% P change ≈ –D × ∆Y (in percentage points)

How duration is changed impacts final result

Duration Current Alternative 1 Alternative 2

Position 1 (cash) 0 33% 0 33%
Sovereign 1 4 33% 50% 0
Sovereign 2 8 33% 50% 0
Sovereign 3 6 0 0 33%
Sovereign 4 12 0 0 33%
Market-weighted duration 4 6 6

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Duration Management (2/2)
Futures contracts
Nf = Required additional PVBP / PVBP of the futures contract

Leverage
MV of bonds to be purchased = (Additional PVBP / Duration of bonds to be purchased ) x 10,000

Effective portfolio duration ≈ (Notional portfolio value / portfolio equity ) x duration

Swaps

Effective PVBP Effective PVBP Net Effective PVBP per

Maturity Receive Fixed Pay Floating PVBP Million
5-Year 0.0485 0.0025 0.0460 460
10-Year 0.0933 0.0025 0.0908 908
20-Year 0.1701 0.0025 0.1676 1,676

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Buy Convexity
When yield changes, convexity is good for a bondholder
If yield is expected to change  add convexity
• Higher convexity bonds are more expensive (lower yield)
• Anticipated decline must happen quickly

How can we ‘buy convexity’?

• Alter portfolio structure
• Add instrument with curvature (call option)

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Bullet and Barbell Structures
Bullet Portfolios
• Securities targeting a single segment of the yield curve
• Take advantage of a steepening yield curve

Barbell Portfolios
• Securities concentrated in short and long maturities
• Take advantage of a flattening yield curve

Key rate durations (KRD, partial durations) measure duration at key points on the yield curve
• Used to identify bullets and barbells
• Sum of KRDs ≈ effective duration

Embedded Example
• Portfolios 1 and 2 have the same effective duration but different KRDs and convexity
• Portfolio 1 is more ‘bulleted’ and Portfolio 2 is more ‘barbelled’
• Portfolio 1 outperforms if yield curve steepens; Portfolio 2 outperforms if yield curve flattens

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Example 1: Yield Curve Strategies
During a recent meeting of the investment committee of Sanjit Capital Management Co. (Mumbai), the portfolio
managers for the firm’s flagship fixed-income fund were asked to discuss their expectations on Indian interest rates
over the course of the next 12 months. Indira Gupta expects the yield curve to steepen significantly, with short rates
falling in response to a government stimulus package and long rates rising as non-domestic investors sell their bonds
in response to a possible sovereign credit rating downgrade. Vikram Sharma also sees short rates declining as the
Reserve Bank of India substantially lowers its policy rate to stimulate economic growth, but he expects the long end
of the curve to remain unchanged. He has only moderate conviction in his forecast for the long end of the curve.
Ashok Pal disagrees with his co-workers. He believes the Indian economy is doing quite nicely and expects interest
rates to remain stable during the next year.
From the following list, identify which yield curve strategy each of the three portfolio managers would most likely
use to express his or her yield curve view. Justify your response.
• Roll down/ride the yield curve
• Sell convexity
• Carry trade
• Duration management
• Buy convexity
• Bullet
• Barbell

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4 Formulating a Portfolio Positioning Strategy Given a
Market View
Sections:
1. Duration Positioning in Anticipation of a Parallel Upward Shift in the Yield Curve
2. Portfolio Positioning in Anticipation of a Change in Interest Rates, Direction Uncertain
3. Performance of Duration-Neutral Bullets, Barbells, and Butterflies Given a Change in the Yield Curve
4. Using Options

Modifying a portfolio for the anticipated yield curve change requires the following an understanding of:
• the benchmark
• the role the portfolio is intended to fill in the client’s portfolio
• any client-imposed constraints
• current portfolio characteristics
Analyst should have a yield forecast and knowledge of the portfolio positioning strategies most applicable to the
anticipated yield curve environment

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4.1 Duration Positioning in Anticipation of a Parallel
Upward Shift in the Yield Curve
Hillary Lloyd is a portfolio manager at AusBank. She manages a portfolio benchmarked to the XYZ Short- and
Intermediate-Term Sovereign Bond Index, which has an effective duration of 2.00. Her mandate allows her
portfolio duration to fluctuate ±0.30 year from the benchmark duration.
Lloyd is highly confident that yields will increase by 60 bps across the curve in the next 12 months.
Next 12-Month Yield
Next 12-Month Price and Forecast and Holding
Return Expectations Implied Forward Yield Period Return Estimation
Security Descriptor (all are par under Assumption of and Implied Yield under Forecast Interest
bonds) Stable Yield Curve Change Rate Change (+60 bps)
[A] [B] [C] [D] [E] [F] [G] [H] [I]
New Price Holding Implied Implied Holding
Current with Period Forward Yield Yield Curve Period
Maturity Coupon price Rolldowna Return Yieldb Change Forecast Returnc
1 Year 1.50% 100 100.00 1.50% 2.33% 0.83% 2.10% 1.50%
2 Year 1.91% 100 100.40 2.31% 2.61% 0.70% 2.51% 1.72%
3 Year 2.23% 100 100.62 2.85% 2.85% 0.62% 2.83% 1.69%
4 Year 2.50% 100 100.78 3.28% 3.07% 0.57% 3.10% 1.56%
5 Year 2.74% 100 100.90 3.64% 3.27% 0.53% 3.34% 1.41%
6 Year 2.95% 100 100.97 3.92% 3.46% 0.51% 3.55% 1.18%

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4.2 Portfolio Positioning in Anticipation of a Change in
Interest Rates, Direction Uncertain
Maintain duration but add convexity  Create more of a barbelled portfolio

Yield to Effective Effective

Security Coupon Maturity Date Price Maturity Duration Convexity
Brazil 6 month 6.000 17 Jan 2017 102.70 1.110 0.538 0.006
Brazil 3 year 8.875 14 Oct 2019 119.75 2.599 2.895 0.105
Brazil 10 year 6.000 7 April 2026 104.80 5.361 7.109 0.666
Brazil 30 year 5.000 27 Jan 2045 82.50 6.332 13.431 2.827

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4.3 Performance of Duration-Neutral Bullets, Barbells,
and Butterflies Given a Change in the Yield Curve
Securities Portfolios
A B C B AC
Maturity (years) 0.0027 5.075 10.17 5.075 5.086
Yield (%) 2.00% 3.00% 3.40% 3.00% 2.70%
Modified duration 0.00 5.00 10.00 5.00 5.00

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 Securities Portfolios
A B C B AC
Maturity (years) 0.0027 5.075 10.17 5.075 5.086
Yield (%) 2.00% 3.00% 3.40% 3.00% 2.70%
Modified duration 0.00 5.00 10.00 5.00 5.00

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 Securities Portfolios
A B C B AC
Maturity (years) 0.0027 5.075 10.17 5.075 5.086
Yield (%) 2.00% 3.00% 3.40% 3.00% 2.70%
Modified duration 0.00 5.00 10.00 5.00 5.00

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Haskell Capital Management

Predicted change = Portfolio par amount × Partial PVBP × (–Curve shift)

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Example 2: Using Partial Durations to Estimate Portfolio
Sensitivity to a Curve Change
Assume Haskell revises his yield curve forecast as shown in Exhibit 31: Yields for the 2-year through 10-year
maturities each decline by 5 bps, and the yield for the 30-year maturity increases by 23 bps.
Which portfolio would Haskell prefer to own under this scenario?

Key Rate PVBPs Total 1 Year 2 Year 3 Year 5 Year 10 Year 20 Year 30 Year
Pro forma portfolio (1) 0.0587 0 0.0056 0.0073 0.0126 0.0127 0.0014 0.0191
More barbelled portfolio (2) 0.0585 0 0.0096 0.0040 0.0074 0.0119 0.0018 0.0238

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Butterflies
Condor: 4 positions. Examples:
Long barbell and a short bullet
Long 2s Short 5s and Short 10s Long 30s
 Benefit from flattening yield curve
 Positive convexity
 More valuable when interest rate volatility is high
Short barbell and a long bullet
 Benefit from steepening yield curve
 Effectively selling convexity Short 2s Long 5s and Long 10s Short 30s
 More valuable when interest rates are stable

Ways to structure wings of a butterfly portfolio:

1. Duration neutral
2. 50/50 weighting
3. Regression weighting

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Example 3: Bullets and Barbells
Base portfolio: YTM = 1.339%, ED = 5.918, EC = 0.828

Portfolio A
Yield to Effective
Security Coupon Maturity Market Price Par Amount Weight Maturity Duration Effective Convexity
US 2 year 0.750 2/28/2018 99.836 45,000,000 0.75 0.840 1.920 0.046
US 3 year 1.000 3/15/2019 99.992 0.00 1.000 2.940 0.101
US 5 year 1.125 2/28/2021 99.008 0.00 1.330 4.810 0.259
US 7 year 1.500 2/28/2023 99.000 — 0.00 1.650 6.630 0.485
US 10 year 1.625 2/15/2026 97.781 — 0.00 1.870 9.220 0.936
US 30 year 2.500 2/15/2046 96.453 15,000,000 0.25 2.670 21.850 5.959
60,000,000 1.00 1.298 6.903 1.524
Portfolio B
Yield to Effective Effective
Security Coupon Maturity Market Price Par Amount Weight Maturity Duration Convexity
US 2 year 0.750 2/28/2018 99.836 — 0.00 0.840 1.920 0.046
US 3 year 1.000 3/15/2019 99.992 — 0.00 1.000 2.940 0.101
US 5 year 1.125 2/28/2021 99.008 5,000,000 0.08 1.330 4.810 0.259
US 7 year 1.500 2/28/2023 99.000 45,000,000 0.75 1.650 6.630 0.485
US 10 year 1.625 2/15/2026 97.781 10,000,000 0.17 1.870 9.220 0.936
US 30 year 2.500 2/15/2046 96.453 — 0.00 2.670 21.850 5.959
60,000,000 1.00 1.660 6.910 0.541

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4.4 Using Options
Effective Yield to Accrued Market
Security Coupon Maturity Convexity Maturity Price Interest Nominal Effective Par Value Value
US 2 year 0.750 28 Feb 2018 0.046 0.84 99.836 0.045 1.92 1.92 10,000 9,988
US 3 year 1.000 15 Mar 2019 0.101 1.00 99.992 0.019 2.93 2.94 10,000 10,001
US 5 year 1.125 28 Feb 2021 0.259 1.33 99.008 0.067 4.78 4.81 10,000 9,908
US 7 year 1.500 28 Feb 2023 0.485 1.65 99.000 0.090 6.56 6.63 10,000 9,909
US 10 year 1.625 15 Feb 2026 0.936 1.87 97.781 0.161 9.08 9.22 10,000 9,794
US 30 year 2.500 15 Feb 2046 5.959 2.67 96.453 0.247 20.72 21.85 10,000 9,670
Total portfolio 1.417 9.4 Yrs. 1.276 1.55 98.693 0.104 7.59 7.82 60,000 59,270

Instrument PVBP Price Delta Convexity Convexity can be added using options
Call option 0.149 3.97 0.644 826.041
June 2016 30-year bond future 0.2354 163.22
30-Year bond 0.2113 106.82

Effective Effective Yield to Accrued

Security Coupon Maturity Convexity Duration Maturity Price Interest Par Value Market Value
Cash 0.508 23 Mar 2016 0 0 0.508 100.000 0 6,193 6,193
US161F6 0 20 May 2016 826.041 375.30 n/a 3.970 0 9,640 383
US 2 Year 0.750 28 Feb 2018 0.046 1.92 0.835 99.836 0.045 10,000 9,988
US 3 Year 1.000 15 Mar 2019 0.101 2.94 1.003 99.992 0.019 10,000 10,001
US 5 Year 1.125 28 Feb 2021 0.259 4.81 1.333 99.008 0.067 10,000 9,908
US 7 Year 1.500 28 Feb 2023 0.485 6.63 1.653 99.000 0.090 10,000 9,909
US 10 Year 1.625 15 Feb 2026 0.936 9.22 1.871 97.781 0.161 10,000 9,794
US 30 Year 2.500 15 Feb 2046 5.959 21.85 2.673 96.453 0.247 3,200 3,094
Total Portfolio: 1.031 5.3 years 5.952 7.82 1.32 85.791 0.067 69,033 59,270

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Adding Convexity with Options
Yield Scenario –75 –50 –25 0 +25 +50 +75
Total Return:
Pre-trade portfolio 6.495 4.358 2.309 0.344 –1.542 –3.354 –5.097
Post-trade portfolio 7.321 4.820 2.417 0.113 –1.645 –2.920 –4.149
Difference +0.826 +0.462 +0.108 –0.231 –0.103 +0.434 +0.948

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Changing Convexity Using Securities with Embedded Options
To reduce convexity sell options or buy MBS

Starting position = $10 million US Treasury Note 1.375% maturing 31 January 2021; effective duration = 4.72
Manager’s expectation: low yield volatility over a short horizon
Strategy: Sell convexity by selling the Treasury and buying the 30-year Federal National Mortgage Association
(FNMA) 3% MBS, which has a slightly shorter effective duration of 4.60
Yield Scenario –75 –50 –25 0 +25 +50 +75
FNMA 30-year 3% 2.647 2.204 1.458 0.432 –0.855 –2.340 –3.941
US 1.375% 31 Jan 2021 3.774 2.588 1.417 0.262 –0.879 –2.005 –3.117
Difference –1.127 –0.384 0.041 0.17 0.024 –0.335 –0.824

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5 Comparing the Performance of Various Duration-
Neutral Portfolios in Multiple Curve Environments

1. The Baseline Portfolio

2. The Yield Curve Scenarios

3. Extreme Barbell vs. Laddered Portfolio

4. Extreme Bullet

5. A Less Extreme Barbell Portfolio vs. Laddered Portfolio

6. Comparing the Extreme and Less Extreme Barbell Portfolios

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5.1 The Baseline Portfolio
Laddered Portfolio
Market Value Yield to Effective
Bond Nominal (millions) Coupon Maturity Price Maturity Duration
1 2 year 10 0.875 30 Nov 2017 99.828 0.964 1.939
2 3 year 10 1.250 15 Dec 2018 99.891 1.287 2.946
3 5 year 10 1.625 30 Nov 2020 99.672 1.694 4.785
4 7 year 10 2.000 30 Nov 2022 99.656 2.053 6.550
5 10 year 10 2.250 15 Nov 2025 99.859 2.266 8.992
6 30 year 10 3.000 15 Nov 2045 100.172 2.991 20.364
Portfolio 60 1.876 7.596

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5.2 The Yield Curve Scenarios
Maturity(years) Starting Yield Parallel –100 Parallel +100 Flatter Steeper Less Curvature More Curvature
2 0.964 0.010 1.964 0.964 0.964 0.892 1.036
3 1.287 0.287 2.287 1.269 1.305 1.174 1.400
4 1.490 0.490 2.490 1.455 1.526 1.337 1.644
5 1.694 0.694 2.694 1.640 1.748 1.499 1.889
7 2.053 1.053 3.053 1.964 2.142 1.776 2.330
10 2.266 1.266 3.266 2.123 2.409 1.866 2.666
20 2.629 1.629 3.629 2.308 2.950 2.429 2.829
30 2.991 1.991 3.991 2.491 3.491 2.991 2.991

2s–30s Spread 2s 30s Spread Butterfly spread 2s 10s 30s Spread

Starting yield curve 0.964 2.991 2.027 Starting yield curve 0.964 2.266 2.991 0.577
Flatter 0.964 2.491 1.527 Less curvature 0.892 1.866 2.991 –0.151
Steeper 0.964 3.491 2.527 More curvature 1.036 2.666 2.991 1.305

Butterfly spread = – 2-Year yield + (2 × 10-Year yield) – 30-Year yield

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5.3 Extreme Barbell vs. Laddered Portfolio
Market
Value Yield to Effective
Bond Nominal (millions) Coupon Maturity Price Maturity Duration
1 2 year 41.58 0.875 30 Nov 2017 99.828 0.964 1.939
2 3 year 1.250 15 Dec 2018 99.891 1.287 2.946
3 5 year 1.625 30 Nov 2020 99.672 1.694 4.785
4 7 year 2.000 30 Nov 2022 99.656 2.053 6.550
5 10 year 2.250 15 Nov 2025 99.859 2.266 8.992
6 30 year 18.42 3.000 15 Nov 2045 100.172 2.991 20.364
Portfolio 60.00 1.586 7.595
Extreme Barbell Benchmark
Portfolio Portfolio
Duration 7.595 7.596
Convexity 1.578 1.134
Yield Curve Scenario Return Return Return Difference
-100 8.517 8.241 0.276
+100 –6.823 –7.041 0.218
Flatter 3.243 2.125 1.118
Steeper –2.971 –1.974 –0.997
Less curvature 0.107 1.146 –1.039
More curvature –0.107 –1.124 1.017

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5.4 Extreme Bullet
Market Value Yield to Effective
Bond Nominal (millions) Coupon Maturity Price Maturity Duration
1 2 year 0.875 30 Nov 2017 99.828 0.964 1.939
2 3 year 1.250 15 Dec 2018 99.891 1.287 2.946
3 5 year 1.625 30 Nov 2020 99.672 1.694 4.785
4 7 year 34.25 2.000 30 Nov 2022 99.656 2.053 6.550
5 10 year 25.75 2.250 15 Nov 2025 99.859 2.266 8.992
6 30 year 3.000 15 Nov 2045 100.172 2.991 20.364
Portfolio 60.00 2.144 7.598

Extreme Bullet Benchmark

Portfolio Portfolio
Duration 7.598 7.596
Convexity 0.643 1.134
Yield Curve Scenario Return Return Return Difference
-100 7.939 8.241 –0.302
+100 –7.277 –7.041 –0.236
Flatter 0.881 2.125 –1.244
Steeper –0.875 –1.974 1.099
Less curvature 2.590 1.146 1.444
More curvature –2.534 –1.124 –1.410

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5.5 A Less Extreme Barbell Portfolio vs. Laddered Portfolio
Market Value Yield to Effective
Bond Nominal (millions) Coupon Maturity Price Maturity Duration
1 2 year 17.66 0.875 30 Nov 2017 99.828 0.964 1.939
2 3 year 12.65 1.250 15 Dec 2018 99.891 1.287 2.946
3 5 year 1.625 30 Nov 2020 99.672 1.694 4.785
4 7 year 2.000 30 Nov 2022 99.656 2.053 6.550
5 10 year 19.35 2.250 15 Nov 2025 99.859 2.266 8.992
6 30 year 10.34 3.000 15 Nov 2045 100.172 2.991 20.364
Portfolio 60.00 1.801 7.601

Less Extreme Benchmark

Barbell Portfolio Portfolio
Duration 7.601 7.596
Convexity 1.183 1.134
Yield Curve Scenario Return Return Return Difference
-100 8.269 8.241 0.028
+100 –7.012 –7.041 0.029
Flatter 2.239 2.125 0.114
Steeper –2.083 –1.974 –0.109
Less curvature 1.287 1.146 0.141
More curvature –1.256 –1.124 –0.132

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5.6 Comparing the Extreme and Less Extreme Barbell
Portfolios
Less Extreme
Extreme Barbell Barbell
Duration 7.595 7.601
Convexity 1.578 1.183
Yield Curve Scenario Return Return Return Difference
-100 8.517 8.269 0.248
+100 -6.823 -7.012 0.189
Flatter 3.243 2.239 1.004
Steeper -2.971 -2.083 -0.888
Less curvature 0.107 1.287 -1.180
More curvature -0.107 -1.256 1.149

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Exhibit 53 Relative Performance of Bullets and Barbells
under Different Yield Curve Scenarios

Yield Curve Scenario Barbell Bullet

Level change Parallel shift Outperforms Underperforms
Slope change Flattening Outperforms Underperforms
Steepening Underperforms Outperforms
Curvature change Less curvature Underperforms Outperforms
More curvature Outperforms Underperforms
Rate volatility change Decreased rate volatility Underperforms Outperforms
Increased rate volatility Outperforms Underperforms

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Example 4: Positioning for Changes in Curvature and Slope
Heather Wilson, CFA, works for a New York hedge fund managing its US Treasury portfolio. Her role is to take
positions that profit from changes in the curvature of the yield curve. Wilson’s positions must be duration neutral,
and the maximum position that she can take in 30-year bonds is $100 million. On-the-run Treasuries have the
characteristics shown in the following table:

Yield to
Maturity Coupon Price Maturity Duration PVBP/$ Million
2 Year 1.0% 100 1.0 1.98 198
5 Year 1.5% 100 1.5 4.80 480
10 Year 2.5% 100 2.5 8.80 880
30 Year 3.0% 100 3.0 19.72 1,972

If Wilson takes the maximum allowed position in the 30-year bonds

and all four positions have the same (absolute value) money
duration, what portfolio structure involving 2s, 5s, 10s, and 30s will
profit from a decrease in the curvature of the yield curve?

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6 A Framework for Evaluating Yield Curve Trades
E(R) ≈ Yield income

+ Rolldown return

+ E(Change in price based on investor’s views of yields and spreads)

- E(Credit losses)

+ E(Currency gains or losses)

Expected gain/loss from change in yield ≈ [-MD × ∆Yield] + [½ × Convexity × (∆Yield)2]

Calculation of forward rates

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Victoria Lim
Buy-and-Hold Portfolio Ride the Yield Curve Portfolio
Investment horizon (years) 1.0 1.0
Bonds maturity at purchase (years) 1.0 2.0
Coupon rate 0.00% 0.00%
Yield to maturity 1.00% 2.00%
Current average bond price for portfolio 99.0090 96.1169
Expected average bond price in one year for portfolio 100.00 99.0090
Expected currency gains or losses 1.5% 1.5%

If forecasted ending yield < forward rate  expected return > one-period rate
If forecasted ending yield > forward rate  expected return < one-period rate

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Lamont Cranston
Bullet Barbell
Investment horizon (years) 1.0 1.0
Average bond price for portfolio currently 94.5392 92.6437
Average bond price for portfolio in one year (assuming 96.0503 94.3525
stable yield curve)
Current modified duration for portfolio 4.97 4.93
Expected effective duration for portfolio (at the horizon) 3.98 3.98
Expected convexity for portfolio (at the horizon)* 17.82 32.57
Expected change in US Treasury zero-coupon yield curve 0.50% 0.50%

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Example 5: Components of Expected Returns
Yield Curve Shift
Initial Portfolio Initial Portfolio Revised Portfolio
Investment horizon (years) 1.0 1.0 1.0
Average annual coupon rate for portfolio 2.01% 2.01% 1.91%
Average beginning bond price for portfolio 100.00 100.00 100.00
Average ending bond price for portfolio (assuming rolldown and stable 100.46 100.46 100.40
yield curve)
Expected effective duration for portfolio (at the horizon) 1.313 1.305 0.979
Expected convexity for portfolio (at the horizon) 0.9 0.9 0
Expected change in government bond yield curve — 0.60% 0.60%

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Using Structured Notes in Active Fixed-Income Management
There is a class of fixed-income securities that can provide highly customized exposures to alter a portfolio’s
sensitivity to yield curve changes. These securities fall under the broad heading of structured notes. Among the
many types of structured notes used in fixed-income portfolio management are the following:
• Inverse floaters
• Deleveraged floaters
• Range accrual notes
• Extinguishing accrual notes
• Interest rate differential notes
• Ratchet floaters

Structured notes can offer significantly lower all-in costs compared with traditional financing. When used by
sophisticated investors, structured notes allow the packaging of certain risks or bets. Some structured notes can be
extremely complicated, with complex formulas for coupon payments and redemption values.

Structured notes can be complicated and often lack liquidity. Thorough due diligence and a high level of
investment expertise are essential to effectively invest in these securities. Many unsophisticated investors have
purchased these securities without truly understanding their idiosyncratic characteristics and risks. The Orange
County debacle of 1994 is one notable example.

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 Conclusion
• Learning objectives

• Summary

• Examples

• Practice Problems

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