Hi Aj,
Bond trading strategies,their explanations, their limitations, their contingencies, and their applications could fill up many pages, so my comments here have to be limited. Also, I am not sure what you already know, so I have to guess a bit.
For starters, "roll down" is a strategy that works as long as the yield curve is upward sloping, meaning that bonds of longer maturity yield more than bonds of shorter maturity. Another important consideration is that the yield curve does not shift upward while trying to take advantage of the "roll down." Put another way, the strategy is reliant on yields staying roughly the same, why? As yields rise it makes bonds with lower yields and similiar maturities and credit qualities less attractive. After all, why would I buy a 30 year maturity bond yielding 4% issued by a AAA credit, when I could buy a 30 year maturity bond just issued and yielding the current market rate of 5% for a AAA credit? Very few would purchase the 4% bond, so its price must fall. And it is the falling price that offsets the benefit of the "roll down" strategy.
So, assuming an upward sloping, stable yield curve, what is the "roll down" strategy?
For me it is helpful to think of bonds with maturities of longer than one year as multiple bonds. Say, for example, I own a 2 year maturity bond yielding 1% that pays interest once a year, this is essentially the same as owning a 1 year maturity bond paying 1% one year from today, another one year bond that won't pay me my 1% interest until the end of two years, and a zero coupon bond that will not pay me my principal amount until the end of year two. When you see bonds of greater than one year maturity in this way then you can compare long-term bonds to short-term bonds to see which one is likely to have a higher expected return given your assumptions for what the yield curve does.
To illustrate this consider the following situation, I have a $1,000 that I want to invest in a bond and I think that the current upward sloping yield curve will remain pretty much the same for the next year and I have a 1 year investment time horizon. Among my options are the following two bonds of comparable credit quality:
a) A 1 year bond yielding 0.5%
b) A 3 year bond yielding 1.5%
I could buy bond a and be paid my $5 in interest at the end of year one, as well as receive my principal of $1,000 back. Or I could buy bond b and sell it at the end of year one and earn $15 in interest at the end of year one and receive my principal back here, too, and likely the principal amount would likely be a bit higher (see below). So that 3 year bond could have been viewed as a 1 year bond by me if I think of bonds as a stream of interest payments and one principal repayment at maturity. So options a and b could be seen as two competing 1 year bonds if I wanted to think of them in that way. By buying b I have triple the return, plus a likely slightly higher principal amount received from the sale, less my trading costs for selling the bond. Obviously, I have taken on greater risk due to the duration and convexity risks in buying the second bond, but if you are confident of the shape of the yield curve this may be a more profitable strategy.
There are two opposing forces at work here. As time passes, a longer term bond becomes a shorter term bond. As a bond advances in age it tends to rise in value because its risk of not suriving to maturity decreases. Working in opposition to this, however, is the force pushing down against the value of the bond: as it advances in age it will pay less total interest so the bond's yield to maturity approaches 0% at the moment just before maturity. Why is this the case? In the 3 year example above there are 4 payments owed to the buyer of the bond when issued: 1) year 1 interest; 2) year 2 interest; 3) year 3 interest; and 4) principal repayment. At the end of year 2 any owner of the bond only receives two additional payments: year 3 interest and principal. This tends to lower the value of the bond.
So the "roll down" term comes because I can buy a longer-term bond and roll with it down the yield curve. I buy a 3 year bond, and sell it at the end of year 1 when it is now a 2 year bond.
Does this make sense? I hope so.
With smiles,
Jason