Monday, August 31, 2009

Use of the yield curve to indicate trade-offs between maturity and yield

Still another use of the yield curve is to indicate the current trade-off between maturity and yield confronting the investor. If the investor wishes to alter the maturity of a portfolio, the yield curve indicates what gain or loss in rate of return may be expected for each change in the portfolio‘s average maturity.
with an upward-sloping yield curve,for example, an investor may be able to increase a bond portfolio‘s expected annual yield from 9 percent to 11 percent by extending the portfolio‘s average maturity from six to eight years. however, the prices of longer-term bonds are more volatile, creating greater risk of capital loss. moreover, longer-term securities tend to be less liquid and less marketable than shorter-term securities. therefore, the investor must weigh the gain in yield from extending the maturity of his or her portfolio against added price, liquidity, and marketability risk. because yield curves tend to flatten out for the longest maturities, the investor bent on lengthening the average maturity of a portfolio eventually discovers that gains in yield get smaller and smaller for each additional unit of maturity. At some point along the yield curve it clearly does not pay to further extend the maturity of a portfolio.

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