## **Learning Outcomes**

This article explains yield curve and duration strategies for fixed income portfolio management, including:

- how carry and roll-down contribute to expected return across different yield curve shapes and interest-rate environments  
- how to distinguish static yield curve positioning from active curve trades targeted at specific segments  
- how to compute and interpret carry, roll-down, and total expected return using yields, prices, and financing costs  
- how to design barbell, bullet, and butterfly structures that express steepening, flattening, and curvature views while controlling overall duration  
- how to apply key rate duration to build duration-neutral curve trades and to isolate exposure to selected maturities  
- how to evaluate the impact of parallel shifts, twists, and changes in curvature on portfolio value and strategy performance  
- how to identify key implementation risks, including funding risk, model risk, liquidity constraints, and basis risk across related instruments  
- how to compare alternative curve strategies and select structures consistent with a stated benchmark, risk budget, and CFA Level 3 exam-style requirements

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand the construction and analysis of fixed income yield curve and duration strategies. Yield curve trades are tested frequently, especially the practical application of carry, roll-down, and curve trades, with a focus on the following syllabus points:

- Describe and evaluate carry and roll-down strategies and their return drivers
- Formulate and assess yield curve and butterfly trades with duration targeting
- Calculate expected gains/losses for carry and roll-down given market data
- Analyse the impact of curve moves on portfolios using key rate duration
- Recognise risks of strategy implementation, including interest rate shifts and curve twists

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is the main difference between a carry trade and a roll-down strategy in fixed income?
2. For an upward-sloping yield curve, what is the expected benefit of rolling down the curve? What is the primary risk to this trade?
3. Briefly explain how a butterfly trade exploits anticipated changes in the yield curve.
4. How would you use key rate durations to structure a flattening curve trade?

## **Introduction**

Yield curve and duration strategies use the shape and movements of the yield curve to generate return in fixed income. Carry and roll-down produce incremental yield by taking advantage of current curve levels and the passage of time. Curve trades, including barbell, bullet, and butterfly structures, seek to profit from expected relative changes in yields at specific maturities. For the CFA Level 3 exam, you must understand these strategies, not just the mechanics but also their risks, return sources, and practical implementation.

> **Key Term: carry trade**
> A strategy aiming to earn yield by holding a bond whose yield exceeds the financing or funding cost, assuming no change in the yield curve.
>
> **Key Term: roll-down return**
> The price return realised as a bond’s maturity declines, assuming a static, non-flat yield curve, when bond yield “rolls down” the curve toward lower yields and higher prices.

## **Carry and Roll-Down Strategies**

Carry and roll-down are central to yield curve positioning.

### Carry

Carry is the yield earned from holding a bond, minus funding or financing costs, and can be positive or negative depending on bond selection and current curve levels.

- For upward-sloping curves, buying bonds with higher yields than short-term rates and financing the position at lower cost can add return.
- The risk of carry is that changes in yields or spread cause mark-to-market losses.

### Roll-Down

Roll-down is the gain a bondholder experiences when the bond "rolls down" the steep part of a non-flat yield curve. As time passes, a 5-year bond becomes a 4-year bond, then 3-year, and so forth. If the curve is upward-sloping, shorter-maturity yields are lower, so the bond’s price rises—producing a capital gain.

- Roll-down is only realised if the curve does not shift up (which would offset the price gain).

### **Worked Example 1.1**

A fund manager holds a 2-year Treasury (yield 3.5%), with 1-year bills yielding 3.0%. The yield curve is expected to remain unchanged. What is the annual carry and roll-down for this position?

> **Answer:**
>
> - Carry: 2-year bond earns 3.5%; cost to fund (using 1-year rate) is 3.0%. Carry is 0.5% per year.
> - Roll-down: As the 2-year becomes a 1-year, its yield falls and price rises (assuming no change to yield curve). The bond gains additional value as yield falls from 3.5% to 3.0%. This price change is the roll-down return.

## **Yield Curve Curve Trades**

Curve trades seek to exploit anticipated relative movements in the yield curve—whether it’s steepening, flattening, or changes in curvature.

### Curve Trade Types

- **Bullet:** Concentrated in intermediate maturities
- **Barbell:** Split between short and long maturities
- **Butterfly:** Long/short exposure to “wings” (short and long maturities) and the “body” (intermediate maturity). Designed to profit from convexity or changes in curve shape.

> **Key Term: butterfly trade**
> A fixed income strategy that seeks to profit from expected changes in the relative yields between the short, intermediate, and long segments of the yield curve.

### Duration Neutrality and Key Rate Duration

Proper curve trades are often structured duration-neutral (overall portfolio duration unchanged), so the strategy's P&L comes strictly from curve movements, not parallel shifts.

> **Key Term: key rate duration**
> The sensitivity of portfolio value to a change in the yield at a specific maturity point on the yield curve, holding all other maturities constant.

### **Worked Example 1.2**

A manager expects the yield curve to flatten (long yields to fall, short yields to rise). The portfolio uses 2-year and 10-year government bonds. How could a duration-neutral flattening trade be constructed?

> **Answer:**
>
> - Short 2-year bonds, long 10-year bonds in amounts that equalise total portfolio duration (using key rate durations).
> - If the curve flattens as expected (2-year yields up, 10-year yields down), the trade earns a positive return.

## **Risks and Implementation Considerations**

While carry and roll-down may seem low-risk, adverse changes in the yield curve—rising yields, twists, parallel shifts—can quickly erase expected returns. Curve trades require careful construction to ensure true exposure to anticipated curve shifts.

### **Worked Example 1.3**

Suppose a butterfly trade is constructed to profit from anticipated curve steepening. What is the main risk if the yield curve instead flattens?

> **Answer:**
> The trade will likely lose money if the expected change in curvature does not occur, as expected gains from the long ends ("wings") will not materialise, while losses may result from shorting the intermediate segment ("body").

### **Exam Warning**

> Poorly structured "carry" or "roll-down" trades can become large sources of loss if the yield curve shifts up in yield or moves against your forecast, not just if the parallel shift is larger than hoped. Always assess return and risk for non-parallel moves.

## **Summary**

Understanding carry, roll-down and curve trades is essential for constructing and managing fixed income portfolios. These strategies are based on the relationship between bond prices and the yield curve and require careful attention to implementation and risk management. For the CFA Level 3 exam, you should know not just how to structure the trades, but also the key sources of return and risk.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Identify carry and roll-down as components of yield curve position return
- Define and calculate carry, roll-down, and their relationship to curve shape
- Construct duration neutral curve trades (barbell, bullet, butterfly)
- Use key rate duration in portfolio construction and scenario analysis
- Recognise the main risks—curve shifts (parallel and non-parallel), unexpected volatility, and basis risk

## **Key Terms and Concepts**

- carry trade
- roll-down return
- butterfly trade
- key rate duration

Yield curve and duration strategies - Carry roll-down and curve trades