Butterfly in Fixed Income Trading Strategies

A "butterfly" strategy allows investors in fixed-income markets to make their decisions based on finding a specific spread when interest rates rise or fall. These investors determine this spread by examining the shape of the yield curve in bond markets. This strategy allows investors to concentrate on a range of values for interest rates, rather than waiting for those rates to reach a specific number before buying or selling bonds.

The butterfly method allows investors to speculate on specific changes in the correlation between the return rates on short-term and long-term bonds. Investors buy government or corporate bonds through their bank or a brokerage services, then execute the butterfly strategy by examining the central portion of an interest rate curve. Depending on the shape of the curve, the investor can employ the butterfly strategy in one of two ways: The investor can purchase mid-term bonds and sell the short-term and long-term instruments, or she can sell the mid-term bonds and buy the short-term and long-term bonds.

An interest rate curve, also known as a yield curve, displays the contrasting rates of return on similar types of bonds that reach their maturity dates at different times. In most cases, the return rates on bonds are directly proportional to their maturity rates. For instance, a 20-year bond will typically have a higher rate of return than a similar 10-year bond. In these instances, the interest rate curve will rise with respect to time on a graph.

The success of the butterfly strategy depends on learning how the center of an interest rate curve will perform in relation to the front and back of that curve. One of the most common applications of the butterfly strategy involves U.S. Treasury bonds. After the investors buy bonds through their bank or a brokerage house, they examine the relationship between the interest rate curves of two-year, five-year and 10-year bonds; the investor can then purchase five-year bonds and sell off a proportionate number of the two-year and 10-year bonds to give his portfolio an average life of five years.

The butterfly strategy has some remarkable advantages for fixed-income investors. On one hand, butterfly trades are quite conservative. The investor risks small maximum losses for the remote possibility of large profits. The strategy also enables investors to make a profit regardless of which way interest rates fluctuate. If the interest rates on short-term bonds rise while those on long-term bonds fall, the butterfly trader can move quickly from one to the other to take advantage of the interest rate spread.