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The Variable Maturity Approach to Fixed Income Investing (Part I)

July 10, 2012 - 0 comments

The variable maturity approach to fixed income investing is based on research by Eugene Fama and Robert Bliss. They concluded that the current yield curve is the best estimate of future yield curves. In other words, if the current yield on a two-year bond is 2%, the best estimate for what a two-year bond will be yielding next year is also 2%.

Dimensional Fund Advisors use this approach with their DFA Five-Year Global Fixed Income Fund. If the yield curve is positively sloped, they will invest in longer-dated bonds (with five years to maturity or less) as long as the additional term risk is compensated for with higher expected returns (longer maturities must provide at least 20 additional basis points per year).

For example, suppose a four-year bond is yielding 2.10% and a similar five-year bond is yielding 2.30%. In this case, since the bond with one year of additional term risk is being compensated for with 20 additional basis points of expected return (2.30% - 2.10% = 0.20%), the four-year bond would be sold and the five-year bond would be purchased.

To illustrate this concept further, I’ve adapted an example from Larry Swedroe’s book, “The Only Guide to a Winning Bond Strategy You’ll Ever Need.”

Suppose we have the choice to invest in either a one-year bond yielding 1% or a two-year bond yielding 2%. Assuming that we do not have superhuman interest rate forecasting abilities (a reasonable assumption), and also assuming that the current yield curve is the best estimate of future yield curves, how would we implement a variable maturity approach?

Step 1: Buy the two-year bond at the beginning of year 1 for $100
Since we receive a full 100 basis points of additional expected return for extending the bond maturity one further year out on the yield curve, we would purchase the two-year bond. At the end of year 1, we are paid the annual interest of $2 and the market value of our bond is now $101.

*Please see below for an explanation of why our two-year bond is now worth $101 at the end of year 1

Why has the value of our bond increased to $101 at the end of year 1? Remember that our main assumption is that the yield curve has not changed after one year. We currently hold a bond that matures at $100 in one year’s time (when it would pay us $2 of interest). Another one-year bond that currently trades in the marketplace is identical in every way to our bond except that it will pay its holder only $1 of interest at the end of the year. How much more could we reasonably expect to sell our bond for (relative to a similar one-year bond trading at par)? The answer is, of course, $1. The purchaser of our bond would receive $1 of additional interest income. Therefore, they would be willing to pay up to $1 more for our bond.

Step 2: Sell the two-year bond at the end of year 1 for $101
Assuming we sell our bond for $101 at the end of year 1 (and realize a capital gain of $1 in the process), we now have a total return of $3 ($2 from the annual interest and $1 from the realized capital gain from the sale of our bond at a premium).

Step 3: Repeat the process
Assuming the yield curve has not changed, we would repeat the process, again buying the two-year bond at the beginning of year 2 (earning a total return of $3 when we sell it at the end of year 2).

In Part II of this blog, I will show investors how they can implement a similar variable maturity approach, using some common fixed income exchange-traded funds (ETFs).


By: Justin Bender with 0 comments.
Filed under: Fixed Income
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