bond principal goes up as it approaches maturity?

Discussion of the Bond portion of the Permanent Portfolio

Moderator: Global Moderator

Post Reply
atrchi
Full Member
Full Member
Posts: 53
Joined: Sat Mar 31, 2012 2:52 pm

bond principal goes up as it approaches maturity?

Post by atrchi » Sat Mar 10, 2018 12:41 pm

For this discussion, assume a normal yield curve and stable interest rates, and ignore transaction costs.

Today a 3-year treasury note has an offer yield of 2.5% while a 1-year t-bill has an offer yield of 2%. In 2 years, a 3-year note bought today will have only 1 year left to maturity, and given above assumptions, will have a market value that yields 2% to maturity. Mathematically the only way this adds up is if the note is selling at a 0.5% premium 2 years from now, for a total annualized return of 2.75% if sold at that time.

The effect is more pronounced when the yield curve is steeper. And the opposite is true if the if the yield curve is inverted or the short-term rate goes up during the holding period, in which case you could hold to maturity.

Is there a name for this phenomenon? I've heard of "bond convexity" but I'm not sure it's the same thing. Are there investment strategies built around the idea of selling bonds at a premium before maturity? Under what economic conditions would such a strategy over-/under-perform? I'm surprised I stumbled upon this in my own head and didn't read about it anywhere.
Post Reply