CFA Level II ExamFixed IncomeHard
A portfolio manager is constructing a portfolio of fixed-income securities and is analyzing the potential impact of various interest rate scenarios. The manager is particularly interested in understanding how the slope of the yield curve affects the returns of different bonds. Which of the following statements about the relationship between yield curve slope and bond returns is most accurate?
- AA flattening yield curve generally benefits short-duration bonds more than long-duration bonds.
- BA steepening yield curve, where long-term rates rise more than short-term rates, is generally detrimental to long-duration bonds.
- CA steepening yield curve generally benefits long-duration bonds more than short-duration bonds.
- DA flattening yield curve, where short-term rates rise more than long-term rates, is generally detrimental to short-duration bonds.
Show answer & explanationAnswer & explanation
Correct answer: B. A steepening yield curve, where long-term rates rise more than short-term rates, is generally detrimental to long-duration bonds.
A steepening yield curve, particularly when it involves long-term rates rising more than short-term rates, is generally detrimental to long-duration bonds. Long-duration bonds are more sensitive to changes in long-term rates, so a significant increase in these rates will cause a larger price decline for long-duration bonds, negatively impacting their returns.
Why the other options are wrong
- A. A flattening yield curve (e.g., long rates falling more than short rates, or short rates rising more than long rates) could benefit long-duration bonds if long rates fall, or be detrimental to short-duration bonds if short rates rise significantly.
- C. A steepening yield curve (especially if long rates rise) would be detrimental to long-duration bonds due to their higher sensitivity to long-term rates.
- D. A flattening yield curve where short-term rates rise more than long-term rates would be detrimental to short-duration bonds because their prices are more sensitive to short-term rate changes.
Yield Curve Slope & Bond Returns
The slope of the yield curve, and how it changes (steepening, flattening), significantly impacts the returns of bonds with different durations.
- Long-duration bonds are more sensitive to long-term rate changes.
- Short-duration bonds are more sensitive to short-term rate changes.
- Steepening (long rates up): bad for long-duration bonds.
- Flattening (long rates down): good for long-duration bonds.
Memory trick: Steep hurts long, Flat helps long.