Owning fixed income investments -- bonds -- can be much more complicated than simply buying a bond directly from the issuer and holding it until its maturity. Through the secondary market, you can also buy and sell bonds in ways that support many different investing strategies. Buying a basket of bonds with a method called a butterfly allows you to speculate on certain changes in the relationship between the returns of short-term and long-term bonds.
A yield curve is a graph that shows the differing rates of returns on a set of bonds that are similar but have different maturities. Typically, the longer it is until the bond matures, the higher its return will be. This usually creates a yield curve that has an upward trajectory. One of the most commonly tracked yield curves is that of U.S. Treasury notes, bills and bonds.
Basics of the Butterfly
Instead of only investing for the yield that the bond offers, investors using a butterfly strategy speculate on the shape of the yield curve. A basic butterfly trade consists of buying and selling three different terms of a given bond. For a bet on a humped yield curve, investors will sell the middle term bond and buy the longer term bonds on the other end, sometimes referred to as the wings of the butterfly. The purchase and sales cancel each other out, making this a theoretically zero-cost investment. This has the impact of cancelling out any shifts in the overall values of the bonds unless the shifts are disproportionately weighted to one maturity over another. When disproportionate shifts occur, the investor can earn a net return.
One common butterfly trade involves three treasury bonds. The investor sells five-year treasuries and buys two- and ten-year bonds with the money that he receives in a proportion that makes the average life of the portfolio equal to five years. To do this, the portfolio would be slightly more heavily weighted towards the two-year bond. To begin with, the idea is for the blended yield of the two- and ten-year bonds to be higher than the five year bond's yield. The other advantage of the butterfly is that if the relationship in yields changes, it could increase returns.
While a traditional butterfly is designed to be cash- and duration-neutral, there are a few ways to get there. By changing the sizes of the wings of the butterfly and adjusting the amount of long and short bonds that you buy and sell, you can customize the butterfly's response to different shifts in the yield curve. For instance, if you think the yield curve will flatten and the relationship between the two- and ten-year bonds will become smaller, you can weight your butterfly towards the two-year bond. In this situation, the two-year bond's lower rate of decline will leave you with a higher net yield after the five- and ten-year bond yields fall more.
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