Download Augmented Returns for Riding the Yield Curve

AUGMENTED RETURNS FROM RIDING THE YIELD CURVE
Karen C. Barr, Pennsylvania State University – Beaver Campus
[email protected]
Raymond A. K. Cox, Central Michigan University
[email protected]
ABSTRACT
This study evaluates the Riding-the-Yield-Curve (RYC) investment
strategy using monthly intervals from 1993 to 2003. Other authors who have
studied this strategy have reported mixed results. We find the RYC technique of
purchasing a 180 day U.S. Treasury bill at a higher return in an upward sloping
yield curve environment, holding it for 90 days, and then selling it as a 90 day Tbill with a capital gain augments returns. When compared to a buy-and-hold
strategy equated to the planned investment period of 90 days the RYC provides an
additional 62 basis points per annum for the eleven years of this study.
I.
INTRODUCTION
The money market investment strategy called Riding-the-Yield-Curve
(RYC) is a method used by many to augment returns. Interest rate conditions in
the recent short term investment market have been extremely low even by
historical standards with rates not seen since the 1930s. Techniques that enable
investors to increase returns, even if by small amounts, need to be employed to
meet operating costs such as management fees of money market mutual funds,
commissions on trading activity and to overcome the bid-ask spread of
transactions.
Ideal conditions for the RYC method are an upward sloping yield curve.
To conduct the RYC method an investor buys a debt security with a longer termto-maturity than the planned investment period. Then when the date of the
planned investment period arrives the security is sold. If the yield curve was
upward sloping and remained the same then the investor earns a higher yield.
This higher yield is because of the higher income return from purchasing the
longer term instrument as well as a capital gain from the sold security due to it
providing a higher return than that required in the market for what is now a
shorter term instrument.
II.
RESEARCH DESIGN
The discount rates of the U.S. Treasury bills with 90 days and 180 days to
maturity are gathered at monthly intervals from the Board of Governors of the
Federal Reserve for the period January 1993 to December 2003.
The reported discount rates must be converted to a discount price as
follows:
P 100  Yd x100 x N / 360
, (1)
Where: P is the discount price of a par 100 bill, Yd is the reported discount
rate, and N is the number of days to maturity.
Then the effective yield is calculated:
RE  100  P  / P  1
365 / N
1
, (2)
Where: RE is the effective yield.
The expected return from the RYC strategy is then computed:
E ( RYC )  R p  [ R p  E Rs ]N p  N H  N H
, (3)
Where: E(RYC) is the expected return from riding the yield curve,
Rp is the effective yield of the T-bill when purchased,
E(Rs) is the expected return of the T-bill when it is sold,
Np is the number of days to maturity when the T-bill was purchased,
NH is the number of days the T-bill was held.
The E(RYC) generated in formula (3) is correct only if the yield curve
does not change. Increases in the interest rate negate the benefits of the RYC
technique and can even make the strategy inferior to the strategy of buying
treasury bills equal to the planned investment period. On the other hand decreases
in interest rates magnifies the augmented returns from the use of the RYC
strategy.
One method to measure the interest rate risk on the RYC strategy is to
calculate the rate at the end of the planned investment period where the investor
would be no better or worse off from the RYC strategy and the strategy of
purchasing a bill with a maturity equal to the planned investment period.
This estimated breakeven point is:
RBEP  R p  ( R p  RPIP ) N H / ( N p  N H )
, (4)
Where: RBEP is the breakeven rate when you sell the T-bill,
RPIP is the return if you originally buy a bill with a maturity equal to the
planned investment period.
If Rs > RBEP the RYC strategy augments returns, otherwise it does not and
can even reduce returns if Rs < RBEP.
Moreover, the wider the distance between RBEP and the E(Rs) (when RYC
augments returns) the better. This difference between the measures is called the
margin of safety (MOS), determined by:
MOS  ( RBEP  E ( Rs )) / E ( Rs )/ 100
, (5)
Equation (5) implies that rates would need to increase by more than the
MOS for the investor to be worse off from employing the RYC technique versus
investing in a bill equal to the planned investment period.
Finally, an investor’s actual return from RYC is:
RYCY  ( Ps  P) / P 1
365 / N
1
, (6)
Where: RYCY is the actual RYC yield,
Ps is the selling price of the T-bill.
III.
RESULTS AND CONCLUSIONS
The RYC strategy is to buy a 180 day U.S. Treasury bill, hold it for 90
days, and then sell it as a 90 day T-bill. This strategy is executed each month for
11 years. Observe Table 1 for the results reported by year (for monthly intervals)
with the average 90 and 180 day T-bill discount rate, average expected RYC rate,
average MOS and average actual RYC including an overall mean and standard
deviation (based on the annual figures). On average the difference between 180
and 90 day U.S. T-bill during 1993 – 2003 was 15 basis points (100 basis points
equals 1%). By executing the stated RYC technique the expected RYC increased
by 57 basis points versus investing in a bill with a maturity the same as the
planned (90 day) investment period. These results are consistent with (Cox and
Felton, 1994) and (Bieri and Chincarini, 2004) as well as (Dyl and Joehnk, 1981).
Rates could have declined on average by 9.11% (MOS) from the base rate. Even
when considering the actual changes in the yield curve the RYC augmented return
by 62 basis points. These results are more remarkable given that in the 11 year
(132 month) period the yield curve was inverted for 12 months and was flat for 2
months.
Even so, the Riding-the-Yield-Curve strategy is an effective technique to
augment return as in each and every month for the 11 year period the actual RYC
yield was superior to the return of the planned investment period.
REFERENCES
Bieri, David S., and Chincarini, Ludwig B. “Riding the Yield Curve:
Diversification of Strategies.” http://econwpa.wustl.edu:8089/eps/fin/
papers/ 0410/0410002.pdf August, 2004.
Cox, Raymond A. K., and Felton, James M. “Performance from Riding the Yield
Curve: 1980-1992.” Journal of Business and Economic Perspectives, 20,
1994, 128-132.
Dyl, Edward A. and Joehnk, Michael D. “Riding the Yield Curve: Does it
Work?” Journal of Portfolio Management, 7, 1981, 13-17.
TABLE 1
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Overall
Average
Standard
Deviation
Average
90 Day T-Bill
Discount Rate
3.07
4.37
5.66
5.15
5.20
4.91
4.78
6.00
3.47
1.63
1.03
4.11
Average
180 Day T-Bill
Discount Rate
3.22
4.82
5.82
5.29
5.39
5.02
4.94
6.17
3.45
1.72
1.08
4.26
Average
Expected
RYC
3.52
5.60
6.40
5.78
5.94
5.45
5.42
6.80
3.49
1.85
1.15
4.68
Average
MOS
11.18
22.38
7.38
7.16
9.07
6.11
8.30
7.81
0.44
10.36
9.97
9.11
Average
Actual
RYC
3.45
4.90
6.63
5.74
5.95
5.63
5.10
7.01
4.44
2.00
1.21
4.73
1.63
1.68
1.88
5.26
1.84