What is Bond Yield Curve?

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Yield Curve

Yield curve establishes the relationship between yield to maturity and number of years to maturity for bonds having same credit quality. For instance, from the plot below, we can make out that a 2 year Treasury bond is having a yield of 3.5, a 10 year Treasury bond is having a yield of 4 and a 12 year bond is having a yield of 6%. Treasuries are issued by the central government of a country and are considered risk free. The yields of treasuries are used as benchmarks for pricing other fixed income instruments.

The yield curve clearly illustrates the spread of yields that arises due to difference in the maturities of the bonds of same asset class.

Shapes of Yield curve

Three types of yield curve have been observed historically. These are:

1.     Normal or upward sloping yield curve:

Here, the investor earns higher yields for holding longer maturity bonds. It is a normal expectation of a market to expect higher yields for holding securities for longer periods due to the risks associated with it. The slope of a yield curve is a good indicator of the economic activity. The yield curve also reflects the investors view about the future interest rates. An upward sloping or steep yield curve indicates an economic upsurge. This states that the economic growth will bring in high inflation which would lead the central banks to increase the interest rates to control the inflation. This will affect the bond returns. Hence, higher inflation and interest rates lead the investors to demand higher yields at longer maturities. As we know, when interest rates increase, bond prices will decrease and yields will rise. In a scenario of normal yield curve, investors should be recommended to invest in longer maturity bonds if they desire higher yields.

2.     Flat yield curve:

Here, the yield does not vary much with the maturities and remains constant. This may be due to the ambiguous signals and expectations of the market. This may indicate a transitionary period to economic expansion or contraction. A flat curve indicates slowdown of economy. This usually happens when central banks try to contain inflation by increasing interest rates, thus increasing short term yields. However, with the actions taken, the expectations of high inflation begin to subside to moderate inflation and expectations of higher long term rates also fall. In such a scenario, investors can be advised to invest in bonds with lower maturities, as they are not being adequately compensated by way of higher yields for the risk of investing in longer dated securities.

3.     Inverted or downward sloping yield curve:

Here, long maturities entail lower yields. This usually indicates economic contraction. Interest rate decline is expected in the future. As interest rates decline, bond prices will move higher and yields will decrease. This may be the result of central banks loosening the monetary policy to revive the economy. Lower interest rates would lower the inflation expectations. Hence, here short term yields are higher than the longer term yields. Though short term yields are greater, few investors may still seek long term bonds as they expect a further economic slowdown where interest rates will further decline resulting in still lower yields.

 

 

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