An Overview of Municipal Yield Curve Strategies

Wesley Phoa, Ph.D.

This paper gives a quantitative overview of a variety of yield curve strategies applicable to the municipal bond market, including generic yield curve strategies and bond vs. curve (i.e. bond selection) strategies. We analyze typical risk/return profiles using historical data. Generic yield curve strategies include:

• global yield curve slope trades,
• local yield curve spread trades,
• global bullet/barbell trades, and
• local butterfly trades.

Constructing and implementing these strategies correctly requires the use of a range of yield curve risk measures such as non-parallel duration and key rate durations.

Bond vs. curve strategies are based on tracking measures spreads to a benchmark curve, and thus make use of either:

• theoretical yield curve models, or
• smoothed "benchmark" yield curves.

No yield curve strategy can succeed if interest rate risk is incorrectly managed, and so we also discuss option-theoretic methods which are required to provide accurate measures of portfolio duration and curve exposure.