Referring to Reading 16 (Capityal market expectations), practice problem 6B, answer says “Extending the duration of the bond portfolio will be profitable when the yield curve subsequently flattens or inverts”. Now when the yield curve flattens, the yield at the long end of the curve falls (bond price increases), and inflation is likely to be less of a concern/interest rates are expected to fall. But can someone please explain why you extend duration when the yield curve flattens?
Note the wording: “Extending the duration of the bond portfolio will be profitable when the yield curve _ subsequently _ flattens or inverts”.
Betting on Ohio State will be profitable if they subsequently beat the Ducks.
I understand the use of subsequently, but why does extending duration mean more profit when the yield curve subsequently flattens or inverts?
flattening of the yield curve will lead to higher prices of long term bonds (long term bonds have higher duration). if you anticipate the yield curve to flatten, you would want to place your funds on long term bonds.
Be careful there; it’s not an absolute.
The yield curve can flatten simply because the short end rises, while the long end stays put (or even rises, but less).
Is my logic correct here, if you anticipate the yield curve to flatten, you would want to place your funds on long term bonds, because their price will increase?
Yup.
Remember, flattening can happen at both ends of the yield curve. Front end could rise.
I shoulda said that.
Oh, wait . . . .
My bad, lol I should read all the replies before jumping in.
For yield curve flattening (with a normal/upward sloping yield curve): - Long-term fall, while short-term doesn’t move. - Long-term fall, while short-term falls by less. - Short term rise, while long-term doesn’t move. - Short term rise, while long-term rises by less. In the case of an inverted yield curve, is everything reverse? That is, For yield curve flattening (with inverted/downward sloping yield curve): - Long-term rise, while short-term doesn’t move. - Long-term rise, while short-term rises by less. - Short-term falls, while long-term doesn’t move. - Short-term falls, while long-term falls by less.