End of Chapter | Yield Strategies Question 9

CFA Level III Fixed Income
#1

Question:

An analyst manages an active fixed-income fund that is benchmarked to the Bloomberg Barclays US Treasury Index. This index of US government bonds currently has a modified portfolio duration of 7.25 and an average maturity of 8.5 years. The yield curve is upward-sloping and expected to remain unchanged.

Which of the following is the least attractive portfolio positioning strategy in a static curve environment?
A Purchasing a 10-year zero-coupon bond with a yield of 2% and a price of 82.035
B Entering a pay-fixed, 30-year USD interest rate swap
C Purchasing a 20-year Treasury and financing it in the repo market

I understand that two tools to get additional return with upward sloping YC is increase duration + leverage (A and C).

I don’t understand the explanation for B: why does the pay fixed swap result in a negative carry (where fixed rate pay exceeds MRR received)? With YC increase, interest rates should be increasing, so shouldn’t MRR received exceed fixed rate payments over time? Thanks!

#2

The fixed rate on a swap is calculated based on the assumption that the yield curve will evolve according to the implied forward rates. With an upward sloping yield curve, this means that it is priced on the assumption that the floating rate will rise. Here, the analyst believes that the yield curve will remain unchanged; i.e., the floating rate won’t rise. Therefore, in a pay fixed swap, he’ll end up losing money; i.e., negative carry.

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#4

If the yield curve is upward sloping (the expectation that the floating rate will rise), even if the analyst believes that the yield curve will remain unchanged… it is still upward sloping so why won’t the floating rate rise?

#5

Because the floating rate is, say, the 6-month rate, and it remains unchanged.

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#7

Sorry for being oblivious or completely missing the ball, but struggling to understand.

I get the logic of your initial answer except the part that “the analyst believe the YC remain unchanged, the floating won’t rise.”

Am I thinking this wrong - YC is synonymous to interest rates… so upward sloping = increase in interest rates. When they say “unchanged” - it means no steepening, shifts or twists? So… isn’t interest rates which = MRR will rise because it is upward sloping?

Any additional material that can help with the YC strategy reading cause it is one that I am struggling with.

#8

The yield curve depicts current interest rates vs. time to maturity. It’s tells you what interest rates are today, not what they will be tomorrow.

Yes.

No.

#9

I am also struggling with this question ARGH

#10

Do you see that with an upward sloping yield curve, the swap fixed rate will be higher than the current 6-month rate?

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