how the roll down return works
the roll down return is a bond trading strategy for selling a bond as it approaches its maturity date as time passes a bond s yield falls and its price rises bond investors perceive greater risk in lending money for a longer period thus demanding higher interest payments as compensation so the initial higher interest rate of the long term bond will decline as its maturity approaches the direction of the roll down depends on whether the bond is trading at a premium or a discount to its face or par value generally as its maturity date grows a bond s interest rate moves closer to zero since there is an inverse relationship between bond yields and prices bond prices increase as interest rates decrease pros and cons of the roll down return strategyhere are some advantages and disadvantages of employing a roll down return strategy capital appreciationpredictabilityexploiting interest rate stabilitymanaging interest rate risksinterest rate riskyield curve dependencylimited upsideopportunity costoverall a roll down strategy can offer predictable and potentially attractive returns in the right yield curve environment however it has specific risks and limitations that investors need to consider carefully understanding the current and expected future state of the yield curve while assessing market conditions is crucial for the roll down return s success example of a roll down returnsuppose you want to employ the roll down return strategy in an upward sloping yield curve environment typically characterized by short term bonds having lower yields than long term bonds you buy a five year bond with a ytm of 3 when the yield for a similar one year bond is 1 you plan to hold the bond for two years before selling it over the next two years as the bond s remaining maturity comes closer its ytm is also closer to the yields found for shorter maturities which are lower in an upwardly sloping yield curve scenario after two years the bond s yield has decreased to mirror those of bonds with a three year maturity if the yield curve remains upward sloping and interest rates are stable the bond s price increases because new investors are willing to accept a lower yield for a bond closer to maturity you would then sell the bond at this higher price realizing capital gains on top of the coupon payments from the previous two years investors would use this strategy expecting the bond price to appreciate as it rolls down the yield curve toward maturity the rationale is that in a normal yield curve scenario the yield required by the market for short dated bonds is lower as the bond approaches maturity its yield is expected to decrease to align with the market yields of bonds with shorter maturities assuming that interest rates are stable this decrease in yield increases the bond s price providing investors with capital gains in addition to the regular coupon payments 