Yield Curve Strategies

Correct Answer: Employ a barbell strategy by investing in a combination of short-term and long-term bonds while underweighting medium-term bonds, as this strategy can benefit from the expected decline in short-term rates while maintaining exposure to the relatively stable long-term rates.

Given the economic outlook and the portfolio's duration constraint, employing a barbell strategy would be the most appropriate approach. This strategy involves investing in a combination of short-term and long-term bonds while underweighting medium-term bonds. The barbell strategy can benefit from the expected decline in short-term rates, as the central bank is likely to cut interest rates to stimulate economic growth. At the same time, the strategy maintains exposure to the relatively stable long-term rates, as the portfolio manager believes that long-term rates will decline at a slower pace than short-term rates. The bullet strategy, which concentrates the portfolio's holdings in medium-term bonds, may not be as effective in this scenario. Although it can take advantage of the potential rolldown return if the yield curve shifts downward in a parallel manner, the given economic outlook suggests that the yield curve changes may not be parallel. The ladder strategy, which evenly distributes the portfolio's holdings across various maturities, can provide a steady income stream and mitigate the impact of interest rate changes on the portfolio's overall performance. However, it may not fully capitalize on the expected yield curve changes, as it maintains equal exposure across different maturities.

Correct Answer: Implement a barbell strategy by investing in a combination of short-term and long-term bonds, maintaining the overall portfolio duration at 5 years. This strategy allows you to benefit from the expected decrease in short-term rates while mitigating the impact of stable long-term rates.

The barbell strategy is the most appropriate given the portfolio manager's economic outlook and portfolio constraints. By investing in a combination of short-term and long-term bonds, the portfolio manager can benefit from the expected decrease in short-term rates resulting from the central bank's anticipated rate cuts. At the same time, the exposure to long-term bonds helps mitigate the impact of the expected stability in long-term rates. This strategy allows the portfolio manager to maintain the overall portfolio duration at the target level of 5 years, aligning with their desired interest rate risk exposure. The bullet strategy is less suitable because it concentrates investments in bonds with maturities close to 5 years, which may not fully capitalize on the expected decrease in short-term rates. The laddered strategy, while diversified, may not provide the optimal positioning to benefit from the portfolio manager's specific economic outlook.

Correct Answer: Maintain the portfolio's current duration and allocate a larger portion of the portfolio to medium-term bonds, which are less sensitive to changes in long-term rates compared to longer-term bonds.

The most appropriate strategy in this scenario is to maintain the portfolio's current duration and allocate a larger portion to medium-term bonds. This strategy aligns with the portfolio manager's economic outlook and constraints. Given that short-term rates are expected to remain low, and long-term rates may rise moderately, medium-term bonds offer a balance between yield and interest rate risk. By maintaining the current duration of 7 years, the portfolio manager ensures that the overall interest rate risk exposure remains unchanged. Allocating more to longer-term bonds would increase the portfolio's duration, making it more sensitive to changes in long-term rates. This goes against the goal of maintaining the current duration level. On the other hand, decreasing the duration by allocating more to shorter-term bonds would reduce the portfolio's yield potential and may not be optimal given the expectation that short-term rates will remain low. Therefore, maintaining the current duration and shifting the allocation towards medium-term bonds is the most suitable approach considering the economic outlook and portfolio constraints.