Yield Curve
A graph of yields over time
What is the Yield Curve?
The Yield Curve is a graphical 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’ yield 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 cycle, but it is typically upward sloping. A Fixed Income Analyst may use the yield curve as a leading economic indicator, especially when it shifts to an inverted shape, which signals an economic downturn, 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 market will generally want more compensation for greater risk. Thus, as long-term securities are exposed to greater 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.
2. Inverted Yield Curve
An inverted curve is when long-term yields fall below short-term yields. 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. 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 Banks 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 inflation due to a rise in aggregate demand. 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 rates.
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 securities have a higher yield.
2. Financial Intermediary
Banks 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. 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 yield. 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 return 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 ignores interest rate risk and reinvestment risk.
2. Liquidity Preference Theory
This theory is an extension of the Pure Expectation Theory where it adds a premium called liquidity premium 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 securities 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 Segmentation 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!
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