Rolling for Return

Douglas J. Peebles

Today’s low interest rates and the uncertainty around the timing of future increases have convinced some bond investors to invest in shorter-term bonds and cash. But yield is just one of several sources of bond returns that investors can pursue, as my colleague Terry Hults explains below.

The Value of Roll

There are multiple sources of bond return. Yield is just one, and yes, today it’s low. Credit is another, and today, credit spreads (the additional yield for buying lower-rated bonds) are wide. A third, which is less well understood, is the value investors receive from rolling down the yield curve—or roll—and it, too, is more beneficial than usual today.

The steeper the yield curve, the more important roll becomes as a source of extra return. Today the municipal yield curve is steep by historical standards. That is, long and intermediate yields are much higher than short-term yields. That’s because investors are demanding high yields for the market risk of holding longer maturity bonds, while the Federal Reserve is keeping short-term interest rates near zero.

Here’s how roll works:  If you buy a seven-year bond today, a year from now it becomes a six-year bond, then a five-year bond, and so on, until it matures. Nevertheless, it always pays its original coupon rate, which is fixed. So, a bond’s time to maturity becomes shorter as you hold it, and yet it continues to pay its original coupon. Active managers can profit by selling the bond before it matures to reap the extra gain from roll.

As the display below shows, the value of roll for a seven-year single-A rated municipal bond is now 2.0%, more than double its 0.85% average since 1973. The value of roll is the amount that the price of a bond is expected to rise if you hold it for a year and market interest rates remain unchanged. For example, if a seven-year single-A bond priced at $100 and the value of roll is 2%, the price of the bond is expected to rise to $102 over the next year.

Roll for Intermedite Bonds Is Historically WideRolling down the yield curve also allows investors to position portfolios at longer durations to capture additional incremental yield, as well as the gain from the sale. When the yield curve is steep, the incremental yield can be substantial.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Head of Fixed Income and Terry Hults is a Senior Portfolio Manager for Municipal Bonds, both at AllianceBernstein.

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