Yield Curve

What is the Yield Curve?

The Yield Curve is a graphicalTypes of GraphsTop 10 types of graphs for data presentation you must use - examples, tips, formatting, how to use these different graphs for effective communication and in presentations. Download the Excel template with bar chart, line chart, pie chart, histogram, waterfall, scatterplot, combo graph (bar and line), gauge chart, representation of the interest rates on debt for a range of maturities. It shows the yield an investor is expected to earn if he lends his money for a given period of time.  The graph displays the bonds’ yieldYieldYield is the income-only return on investment calculated by taking dividends or net income and dividing them by the value of the investment, percentage on the vertical axis and the time to maturity across the horizontal axis.  The curve may take different shapes at different points in the economic cycleBusiness CycleA business cycle is a cycle of fluctuations in the gross domestic product (GDP) around its long-term natural growth rate. It explains the expansion, peak, recession, depression, trough, recovery, expansion, and the entire business cycle keeps repeating in this loop. See examples and descriptions of the stages., but it is typically upward sloping. A Fixed IncomeFixed Income TradingFixed income trading involves investing in bonds or other debt security instruments. Fixed income securities have several unique attributes and factors that affect their price and value. Fixed income investing is favored by investors who prefer low-risk investments with a guaranteed return. Analyst may use the yield curve as a leading economic indicatorEconomic IndicatorsAn economic indicator is a measure of the overall state of the macroeconomy. Economic indicators are often collected by a government agency or private business intelligence organization in the form of a census or survey, which is then analyzed further to generate an economic indicator. Analysts and investors, especially when it shifts to an inverted shape, which signals an economic downturnThe Great DepressionThe Great Depression was a worldwide economic depression that took place from the late 1920s to the early 1930s. For decades debates have been going on abou, as long-term returns are lower than short-term returns.

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Types of Yield Curves

1. Normal Yield Curve

This is the most common shape for the curve and therefore it is referred to as the Normal Yield Curve. This curve is upward sloping, reflecting that it is riskier to lend money for 30 years, rather than 10 years. If you think about it intuitively, if you are lending your money for a longer period of time, you expect to earn a higher compensation for that.

The positively sloped yield curve is called normal because a rational marketPrimary MarketThe primary market is a financial market where new securities are issued and become publicly available for trading by individuals and institutions. The trading activities of the capital markets are separated into the primary market and secondary market. In these markets, securities are directly issued to the investors will generally want more compensation for greater risk. Thus, as long-term securities are exposed to greater risk,Systematic RiskSystematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. Systematic risk is caused by factors that are external to the organization. All investments or securities are subject to systematic risk and therefore, it is a non-diversifiable risk. the yield on such securities will be greater than low-risk short-term securities. A longer period of time increases the probability of unexpected negative events to take place, hence a long-term maturity will have a higher volatility.VIXThe Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market,

2. Inverted Yield Curve

An inverted curve is when long-term yields fall below short-term yields.Calculating Yield on DebtDebt yield refers to the rate of return an investor can expect to earn if he/she holds a debt instrument until maturity. Such instruments includ Inverted yield curve occurs due to the perception of long-term investors that yields will decline in the future. This can happen for a number of reasons, but one of the main reasons is an expectation of a decline in inflation.InflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me When the yield curve starts to shift towards an inverted shape, it is perceived as a leading indicator of an economic downturn. These changes of the yield curve have historically reflected the market sentiment and expectations of the economy.

3. Steep Yield Curve

A steep curve indicates that the long-term yields are rising at a faster rate than short-term yields. Steep yield curves have historically indicated the start of an expansionary economic period. Both the normal and steep curves are based on the same properties but the only difference is that a steeper curve has a larger difference between short term and long term return expectations.

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4. Flat Yield Curve

A flat curve happens when all maturities have similar yields. This means that the yield of a 10-year bond is essentially the same as of a 30-year bond. A flattening of the yield curve usually occurs when there is a transition between the normal yield curve and the inverted yield curve

5. Humped Yield Curve

A humped yield curve is when medium-term yields are greater than both the short-term yields and long-term yields. A humped yield curve is rare and typically indicates a slowing of economic growth. The Humped Yield Curve is quite rare and rarely occurs.

Factors Influencing Yield Curves

1. Inflation

Central BanksEuropean Central BankThe European Central Bank (ECB) is the central bank for all the European Union (EU) member states. The body has the responsibility to the euro... tend to respond to a rise in expected inflation with an increase in interest rate.  A rise in inflation leads to a decrease in purchasing power, and therefore investors expect an increase in the short-term interest rate.

2. Economic Growth

Strong economic growth may lead to an increase in inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me due to a rise in aggregate demandAggregate Supply and DemandAggregate supply and demand refers to the concept of supply and demand, but applied at a macroeconomic scale. Both aggregate supply and aggregate demand are. Strong economic growth also means that there is a competition of capital with more options to invest for investors. Thus, a strong economic growth indicates an increase in yields and leading to a steeper curve.

3. Interest Rates

If the central bank raises the interest rate on Treasuries, this increase will result in high demand for treasuries and thus eventually lead to a decrease in interest ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods..

Importance of Yield Curve

1. Forecasting Interest Rates

The shape of the curve helps investors get a sense about the future course of interest rates. A normal upward sloping curve means that long-term securities have a higher yield. Whereas if it is an inverted curve,  short-term securitiesTrading SecuritiesTrading securities are securities that have been purchased by a company for the purposes of realizing a short-term profit. Companies do not intend to hold have a higher yield.

2. Financial Intermediary

BanksBanking (Sell Side) CareersThe banks, also known as Dealers or collectively as the Sell Side, offer a wide range of roles like investment banking, equity research, sales & trading and other financial intermediaries borrow most of their funds by selling short-term deposits and lend by using long-term loans. The steeper the upward sloping yield curve is, the wider is the difference between lending and borrowing rates and the higher is their profit.Profit MarginIn accounting and finance, profit margin is a measure of a company's earnings relative to its revenue. The three main profit margin metrics are gross profit (total revenue minus cost of goods sold (COGS) ), operating profit (revenue minus COGS and operating expenses), and net profit (revenue minus all expenses) A flat or downward sloping curve, on the other hand, would mean that there will be a decrease in the profits of the financial intermediaries.

3. The Tradeoff between Maturity and Yield

Yield curve helps indicate the tradeoff between maturity and yieldRisk and ReturnIn investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk.. If the yield curve is upward sloping, to increase his yield the investor must invest in long-term securities, which will mean more risk as there is low liquidity.

4. Overpriced or Underpriced Securities

Yield curve tells investors if a security is temporarily overpriced or underpriced. If a security’s rate of returnRate of ReturnThe Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas for calculating different types of rates of returns including total return, annualized return, ROI, ROA, ROE, IRR lies above the yield curve, this means that the security is underpriced and if the rate of return lies below the yield curve, it means that the security is overpriced.

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Yield Curve Theories

1. Pure Expectation Theory

This theory assumes that the various maturities are substitutes and the shape of the yield curve depends on the market’s expectation of future interest rates. According to this theory, yields tend to change over time but the theory fails to define the details of yield curve shapes. This theory ignoresinterest rate risk and reinvestment riskMarket Risk PremiumThe market risk premium is the additional return an investor will receive (or expects to receive) from holding a risky market portfolio instead of risk-free assets. The market risk premium is part of the Capital Asset Pricing Model (CAPM) which analysts and investors use to calculate the acceptable rate.

2. Liquidity Preference Theory

This theory is an extension of the Pure Expectation Theory where it adds a premium called liquidity premiumLiquidity PremiumA liquidity premium compensates investors for investing in securities that have low liquidity. Liquidity here refers to how easily an investment can be sold or term premium. This theory considers the risk involved in holding long-term debts over short-term debts.

3. Market Segmentation Theory

This theory is based on the separate demand and supply relationship between short-term securities and long-term securities because it is based on the fact that different maturities of securities cannot be substituted for one another. Since investors will prefer short-term maturity securities over long-term maturity securitiesHeld to Maturity SecuritiesHeld to maturity securities are securities that companies purchase and intend to hold until they mature. Unlike with trading securities or available for because the former offers low risk, the price of short-term securities will be high, and thus, the yield will be low.

4. Preference Habitat Theory

This is an extension of the Market SegmentationBusiness SegmentA business segment is a subsection of a company’s overall area of operation in which there is an established separate product line. A business segment can be identified by the product or services provided or by geographical locations that the company operates in. Senior management typically divides the overall company Theory. According to this theory, investors prefer a certain investment horizon and to invest outside this horizon, they will need some premium along with the interest. This theory explains the reason behind long-term yields being greater than short-term yields. Short-term investors will prefer investing in fixed interest short-term markets than long-term markets.

Additional Resources

If you want to learn more about Yield Curves and how to Price Bonds, check out CFI’s Fixed Income Fundamentals Course, a prerequisite for the FMVA™ Certification!FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy.

Here are some other resources that you might find interesting:

• Economic IndicatorsEconomic IndicatorsAn economic indicator is a measure of the overall state of the macroeconomy. Economic indicators are often collected by a government agency or private business intelligence organization in the form of a census or survey, which is then analyzed further to generate an economic indicator. Analysts and investors
• BloombergBloomberg Functions SpreadsheetThis Bloomberg functions spreadsheet contains a list of some of the most common and important functions, keystrokes and shortcuts to know on the Bloomberg Terminal. These Bloomberg functions will help you navigate the Bloomberg Terminal more efficiently for grabbing historical financial information about a company, sha
• Big Mac IndexBig Mac IndexThe Big Mac Index is a tool devised by economists in the 1980s to examine whether the currencies of various countries are at their desired
• Interest RateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods.