Trading Build America Bonds in a Shifting Yield Curve Environment

Duration and Convexity Hedging

Build America Bonds, like all fixed-income securities, are sensitive to changes in interest rates. The primary measure of this sensitivity is duration. As interest rates rise, the price of a BAB will fall, and vice versa. However, the relationship is not linear. Convexity measures the curvature of the price-yield relationship. A bond with higher convexity will outperform a bond with lower convexity when interest rates move significantly in either direction. Traders can use these concepts to position their BAB portfolios. For example, in a rising rate environment, a trader might shorten the duration of their portfolio by selling longer-maturity BABs and buying shorter-maturity BABs. Conversely, in a falling rate environment, a trader might extend the duration of their portfolio to maximize price appreciation. More advanced strategies involve convexity hedging, where a trader constructs a portfolio that is neutral to small changes in interest rates but will profit from large changes.

Yield Curve Trades

The shape of the yield curve provides valuable information about the market's expectations for future economic growth and inflation. A steepening yield curve, where long-term rates are rising faster than short-term rates, can signal expectations of stronger economic growth. A flattening yield curve, where short-term rates are rising faster than long-term rates, can signal expectations of a slowing economy. Traders can use BABs to express a view on the future shape of the yield curve. A curve steepener trade might involve buying a long-maturity BAB and shorting a short-maturity BAB. A curve flattener trade would be the opposite. These trades can be constructed to be duration-neutral, meaning they will not be affected by parallel shifts in the yield curve, only by changes in its slope.

The Role of the Federal Subsidy

The 35% federal subsidy on Direct Payment BABs adds a unique dimension to yield curve trading. The value of this subsidy is dependent on the level of interest rates. As interest rates rise, the dollar value of the subsidy increases. This can provide a partial hedge against rising rates. For example, consider a BAB with a 5% coupon. The annual subsidy is $1.75 per $100 of face value (5% * 35%). If interest rates rise and the bond's yield increases to 6%, the price of the bond will fall. However, the subsidy remains at $1.75. This can cushion the blow of rising rates. A sophisticated trader will model the impact of the subsidy on the duration and convexity of their BAB portfolio and adjust their hedging strategies accordingly.*