As we’ve had conversations with clients, heard from consultants, and read in the press, yield-starved investors are turning to riskier asset classes and alternative investments to add income to their portfolios. But what if it didn’t have to be that complicated? What is often overlooked is the possibility to earn a far greater return than the quoted yield on any given bond, even in the current rate environment. In fact, it is possible to earn a return of more than two times the quoted yield if rates stay right where they are…and all we need to do is rely on the passage of time. It’s all possible because of two words: roll return.
Before we dive into the definition of roll return, it’s important to remember the inverse relationship between a bond’s yield and its price. All else equal, the lower the quoted yield on a bond, the greater its price. If we buy a bond at a certain quoted yield and then rates (along with yields) fall, the bond price will rise. That increase in price is known as the “price return” on a bond. Sum the price return with the coupon paid out, and you have the total return of a bond.
Getting back to the roll return of a bond…the roll return is that part of the price return that captures the change in price as the bond moves along the yield curve (moving ever closer to its maturity). If we hold a bond to maturity, we will earn its quoted yield – regardless of how rates move (assuming no default, of course). But if we sell a bond prior to its maturity, we will recognize a price return due to the change in the quoted yield on the bond. And part of that return will come from the change in price as it “rolls” down the yield curve. This powerful source of return is often overlooked and works like this. Currently, a 10-year Treasury bond yields 2.66% while a 9-year Treasury bond yields 2.54%. If we hold that 10-year Treasury bond for one year it will become a 9-year Treasury bond and the yield to discount its cash flows will “roll” from 2.66% to 2.54%. What happens when we discount a bond with a lower rate? Its value will rise.
The intuition underlying the roll return may be considered another way. The yield on a bond is nothing more than the average annualized return the bond will realize over its life. At present, the yield on a one-year Treasury bond is 10 basis points (bps), the yield on a two-year Treasury bond is 33 bps, and the yield on a three-year Treasury bond is 67 bps. What does this mean? We know that if nothing changes, the average annualized return of a 10-year Treasury bond during its last three years will be only 67 bps. So if that 10-year bond has any hope of averaging its stated return of 2.66% over its life, then it must earn much more than its 10-year yield (> 2.66%) during its first seven years in order to offset the measly return during its last three years.
So, the key to realizing the roll return is to buy longer-dated bonds and sell them at some point prior to maturity. But how much potential does the roll return offer? The below table for U.S. Treasurys summarizes the yields, roll returns, and how far rates would need to rise in order to wipe out the one-year roll return.
Notice in the above table that even though the yield on a six-year Treasury bond is only 1.83%, the one-year roll return from holding that six-year bond is 3.76%. This is over double the quoted yield. As well, the six-year Treasury rate would need to rise 67 bps during the next year in order to wipe out this one-year return. Given that the six-year rate is only 1.83%, this would be a very substantial rise. This same concept can be used to pick the optimal maturities of bond holdings to both maximize the roll return as well as to find the points on the yield curve that provide the best protection from a rise in rates.
The point of this exercise is to show those yield-starved investors that they may not be that hungry after all if they know where to go for a good meal. The realized return from investing in Treasury bonds may be much greater than the yield we see quoted for the bond. And this is just the tip of the iceberg. The roll return concept also holds true for riskier bonds with even greater quoted yields and potential roll returns. And the best part is…this isn’t black magic…its math.
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