Throughout the summer we have been executing sales of many of the portfolio’s shorter corporate bonds (2014-2016 maturities) and reinvesting the proceeds in longer bonds from the same issuers. In some cases we have taken the intermediate step of investing sale proceeds in Treasuries until the desired longer-dated corporate bond is available to purchase. These trades are not due to a desire to increase the credit risk exposure of the portfolio (see “How Much Risk”, 7/31/14), but rather to move the portfolio to a more advantageous position with respect to interest rate risk.
Passive Credit Risk Reduction
As corporate credit spreads tightened since the 2008 crisis, we sought to reduce the credit risk exposure of the portfolio. This was partially accomplished by actively swapping corporate bonds for Treasuries. However, a large part of this credit risk exposure reduction was done more passively, by holding the same corporate bonds and allowing the duration of these corporate bonds to shorten over time. In order to maintain the portfolio’s overall duration and interest rate risk positioning, we would extend the maturities of the portfolio’s Treasuries as the corporate bonds’ durations shortened. Eventually, this led to significant holdings of corporate bonds with 0-2 year maturities (see chart at right).
Climbing Back Up The Yield Curve
As the portfolio’s corporate bond holdings drifted shorter, the portfolio’s performance benefitted from “rolling down the yield curve”. This is the benefit of price appreciation due to yields decreasing as time to maturity shortens. This benefit is greatest in the steepest sections of the yield curve. As shown in the snapshot of the yield curve to the right, the curve is flattest from 0- 1 years and steepest from 2-5 years. This means that the bonds moving into the 0-2 year maturity range offer significantly less yield than bonds a few years longer and offer little remaining benefit from rolling down the curve. Therefore, we are now managing the portfolio’s duration by extending the maturity of these shorter corporate bonds to the 4-5 year range. This increases yield and positions more of the bonds in the portfolio to benefit from rolling down the curve.