An investment committee is analyzing three potential Canadian yield curve scenarios for their fixed income portfolio: a steepening curve, an inverted curve, and a 'butterfly' shift where the short and long ends rise while the belly falls. The committee aims to maintain portfolio duration close to its current target but wants to capitalize on the expected curve shape changes. Which of the following strategies best addresses the 'butterfly' shift scenario while maintaining duration discipline?

Question: An investment committee is analyzing three potential Canadian yield curve scenarios for their fixed income portfolio: a steepening curve, an inverted curve, and a 'butterfly' shift where the short and long ends rise while the belly falls. The committee aims to maintain portfolio duration close to its current target but wants to capitalize on the expected curve shape changes. Which of the following strategies best addresses the 'butterfly' shift scenario while maintaining duration discipline?

Answer options: ✅ Increase allocations to short-term and long-term bonds, while reducing exposure to intermediate-term bonds.

• Decrease allocations to short-term and long-term bonds, while increasing exposure to intermediate-term bonds.
• Increase allocations across all maturities uniformly to benefit from rising rates.
• Shift entirely to a barbell strategy, focusing only on the extreme short and long ends of the curve.

Correct answer: Increase allocations to short-term and long-term bonds, while reducing exposure to intermediate-term bonds.

Explanation: A 'butterfly' shift where short and long rates rise but intermediate rates fall suggests that bonds in the 'belly' of the curve will underperform relative to the wings. To capitalize, one would reduce exposure to intermediate-term bonds (which would decline in price) and increase exposure to short-term and long-term bonds (which would likely increase in price or experience smaller declines) while managing overall portfolio duration.