Rolling Down the Curve
Rolling Down the Curve
Rolling down the curve is a bond trading strategy where you buy a bond at a longer maturity and sell it after a few years, capturing a price gain as the bond moves down the yield curve (shorter maturities typically have lower yields).
Key takeaways
- If the yield curve is normal (upward-sloping), a 5-year bond's yield is higher than a 3-year bond's yield. Buy the 5-year, hold two years, then sell it as a 3-year bond.
- As the bond matures (time passes), it moves from the 5-year rung of the curve to the 4-year, then 3-year. If the curve does not change, this time-based move alone creates a price gain.
- Rolling down works best when the curve is steep, when interest rates are stable or falling, and when you have a medium-term (2–5 year) holding period.
- This strategy is active and involves trading (buying and selling), not just holding to maturity. It requires monitoring and market timing skill.
- Works in taxable or tax-deferred accounts, but capital gains taxes are a drag in taxable accounts.
How rolling down works
Scenario 1: Steep, normal yield curve
Suppose the yield curve in 2024 looks like this:
| Maturity | Yield |
|---|---|
| 1 year | 4.0% |
| 2 years | 4.2% |
| 3 years | 4.5% |
| 4 years | 4.7% |
| 5 years | 5.0% |
You buy a 5,000 dollar face value 5-year bond at 5.0% yield. The bond's price is 5,000 dollars (trading at par).
You hold the bond for 2 years. No significant macro change occurs; the curve remains similar. Now it is 2026, and your 5-year bond has become a 3-year bond. If the curve is unchanged, a 3-year bond at par yields 4.5%. But you own a bond with a 5.0% coupon. Since your coupon (5.0%) is higher than the market yield for a 3-year bond (4.5%), your bond trades at a premium.
Bond price calculation (rough):
If interest rates fall such that a 3-year bond at 4.5% par is equivalent to your 5.0% coupon bond, the price of your bond is approximately:
Price = Par + (Coupon Rate - Market Yield) × Duration
Price ≈ 5,000 + (0.05 - 0.045) × 3 × 5,000 Price ≈ 5,000 + 0.005 × 15,000 Price ≈ 5,075 dollars
So you bought at 5,000 dollars, held for 2 years collecting coupons, and can now sell at 5,075 dollars. The 75-dollar gain is from rolling down the curve.
(This is an approximation; actual bond prices depend on exact duration, compounding, and market conditions.)
Three sources of bond returns
To understand rolling down, it is useful to separate bond returns into three components:
-
Coupon income: You collect the bond's stated coupon every year (or semi-annually). A 5% bond pays 5% regardless of market price changes.
-
Roll-down gain: As time passes and the bond matures, it moves from a longer maturity (5-year) to a shorter maturity (3-year). If the curve is steep and stable, shorter maturities have lower yields, so your bond becomes more valuable (premium).
-
Carry loss or gain from rate changes: If interest rates rise after you buy the bond, bond prices fall. If rates fall, prices rise. This is the market-timing component, which is unpredictable.
Rolling down strategy focuses on component 2, the predictable roll-down gain, while minimizing exposure to component 3 (rate risk).
Conditions for rolling down to work
Rolling down works best when:
1. The curve is steep (long yields much higher than short yields). In 2024, the 2-5 year part of the curve was relatively flat (2-year around 4.2%, 5-year around 4.5%), making the roll-down small. In 2019–2020, the 2-5 year spread was much steeper, offering better roll-down gains.
2. Interest rates are stable or falling (not rising). If rates rise uniformly across all maturities, even the roll-down gain is offset by a mark-to-market loss. You buy the 5-year at 5%, rates rise to 5.5%, and now your 3-year bond (which you bought as a 5-year) trades at a loss because 3-year bonds now yield 4.9%, not 4.5%.
3. You have a medium-term holding period (2–5 years). This is long enough to capture the roll-down but short enough to avoid duration risk.
4. You are willing to actively trade (buy and sell bonds, not just hold to maturity). This involves transaction costs (bid-ask spreads, brokerage fees) and tax implications if in a taxable account.
Building a rolling-down ladder
Some investors combine rolling down with laddering:
- Buy a 7-year bond (higher yield).
- Hold for 2 years.
- Sell it (now a 5-year bond) at a gain.
- Use the proceeds to buy a new 7-year bond.
- Repeat.
This is a "rolling ladder" where each position plays the roll-down strategy as it matures. Unlike a traditional ladder (which holds to maturity), a rolling ladder captures price gains and reinvests aggressively.
Example with 100,000 dollars:
- Year 0: Buy 100,000 dollars in 7-year bonds at 4.5% yield.
- Year 2: Sell those bonds (now 5-year bonds) at a 3% gain, netting 103,000 dollars. Use 100,000 to buy new 7-year bonds; keep 3,000 as profit.
- Year 4: Sell those bonds (now 5-year bonds) at another 3% gain, netting 103,000 dollars total in two years. Repeat.
Over a 20-year horizon, a rolling-down strategy could capture 3–4% gain every 2 years, or 30–40% total (far exceeding simple buy-and-hold yield). However, this depends on:
- The curve remaining steep.
- Rates not rising significantly.
- You correctly timing your buys and sells.
- Transaction costs and taxes not eroding gains.
Risks of rolling down
1. Rate risk: If rates rise sharply, bond prices fall faster than the roll-down gain. You bought a 7-year at 4.5% expecting a 3-year gain of 3%. But if rates rise 100 basis points (to 5.5%), your 5-year bond trades at a loss even if the curve has not changed.
2. Curve flattening: If the curve flattens (the spread between 7-year and 3-year yields shrinks), the roll-down gain disappears. A 7-year at 5% and a 3-year at 4.5% has a 50 basis point spread. If the curve flattens and a 3-year now yields 4.8% and a 7-year yields 5.1%, the spread is only 30 basis points. Your roll-down gain is much smaller.
3. Transaction costs: Buying and selling bonds involves bid-ask spreads (typically 0.25–1% per trade). A 3% expected roll-down gain can be significantly eroded by trading costs.
4. Taxes: In a taxable account, selling a bond at a gain triggers a capital gains tax. If you have a 3% gain and pay 20% capital gains tax, your after-tax gain is 2.4%. Over many cycles, taxes can exceed the gross roll-down gain.
5. Reinvestment risk: After selling for a gain, you need to reinvest the proceeds. If the curve has flattened or rates have risen, the new 7-year bond you buy may have lower yield or less roll-down potential.
Rolling down vs. buy-and-hold
| Approach | Expected Return | Complexity | Tax Drag | Rate Risk |
|---|---|---|---|---|
| Buy-and-hold to maturity | Coupon yield only (4–5% in 2024) | Low | Low (no capital gains) | None if rates irrelevant |
| Rolling down | Coupon + roll-down gains (6–8% in steep curve) | High | Medium to high (capital gains taxes) | High (rates rising = losses) |
For a taxable account, the tax drag often makes rolling down less attractive than buy-and-hold. In a tax-deferred account (IRA, RRSP), the tax drag is eliminated, making rolling down more appealing.
A practical rolling-down trade
Suppose it is Q1 2024, the 5-year Treasury yields 4.2%, the 7-year yields 4.4%, and you have 50,000 dollars.
Buy: 50,000 in 7-year Treasury bonds at 4.4%. Price: par (100). You hold them.
Two years later (Q1 2026): Bonds are now 5-year bonds. The 5-year curve point has moved to 4.3% (slight change). Your bonds, with a 4.4% coupon, are worth slightly more than par because they yield more than the market 5-year rate.
Using the bond pricing formula, your bonds are worth approximately 50,000 × 1.001 = 50,050 dollars (rough estimate, depending on duration and exact rate changes).
You sell for 50,050 dollars and collect coupon income of 50,000 × 0.044 × 2 = 4,400 dollars.
Total proceeds: 50,050 + 4,400 = 54,450 dollars.
Return: (54,450 - 50,000) / 50,000 = 8.9% over 2 years, or 4.35% annualized.
Compare to a buy-and-hold 7-year Treasury held for 2 years: 4.4% coupon × 2 = 8.8%, or 4.4% annualized (ignoring reinvestment).
In this scenario, rolling down and buy-and-hold are similar; the roll-down did not add much value because the curve did not change much. But in a steeper environment, the gain would be larger.
When to use rolling down
Good scenarios:
- Tax-deferred account (no tax drag).
- Steep yield curve (5-year vs. 3-year spread >1%).
- Stable or falling rate environment.
- You have active management skills and time to monitor.
- Bond allocation is 20–40% of portfolio (enough to matter, but not dominating).
Poor scenarios:
- Taxable account with high capital gains rate.
- Flat or inverted yield curve.
- Rising-rate environment (like 2022–2023).
- You prefer passive, buy-and-hold strategies.
- Small bond allocation (transaction costs erode gains).
For most individual investors, rolling down is too complex and tax-inefficient in taxable accounts. A simple ladder or buy-and-hold is more robust. In tax-deferred accounts, rolling down becomes more attractive, especially if you are a disciplined trader.
Next
Rolling down captures gains from the curve's shape. A different strategy—the barbell—uses the curve's yield advantage without relying on price gains or trading. Instead, it concentrates holdings at both ends (short and long maturities) while minimizing the middle.