Yield Curve
A yield curve is a graphic image of the yields on bonds with the same credit class but having maturity dates that differ from each other. The slope of a yield curve paints a picture of upcoming changes in interest rate and activity in the economic environment. Three kinds of yield curves are mainly used: normal (upward sloping), inverted (downward sloping), and flat.
More about a Yield Curve
A yield curve is defined as a standard for debt in the market, for example, for bank lending rates. For economists and investors around the world, the yield curve is the most important indicator of the health of the market and global economy as a whole. Thus, the yield curve can be used by investors in order for predicting changes in the volume of production and the direction of the economy and, accordingly, making optimal investment decisions.
For instance, if the yield curve signals about a very likely future slowdown in the economy or an impending recession, investors can take advantage of defensive assets by investing in consumer staples for example, and thereby save their money. A steep slope of the yield curve can indicate upcoming inflation. Then, investors should stay away from long-term bonds, which yields declining as prices rise.
The United States treasury yield curve, sometimes called the term structure of interest rates, is a linear graphical representation of the yield of Treasury bills (short-term), versus the Treasury bonds yield, which are considered long-term ones. The graph shows the presence of a connection between the interest rates and the maturity dates of US Treasury securities with fixed-income. The Treasury yield curve demonstrates yields at specific maturities (1, 2, 3, 6 months, and 1, 2, 3, 5, 7, 10, 20, and 30 years). Due to the constant resale of Treasury bonds on the secondary markets, yields of bills and bonds are constantly subject to fluctuations. The most common yield curve is used for comparing the 3-month, 2-year, 5-year, ten-year, and thirty-year US Treasury debt obligation.
Yield curve risk arises from adverse changes in interest rates when investing in instruments with fixed income, such as bonds. The inverse relationship between bond prices and interest rates is where the main yield curve risk comes from. In the event that the price of bonds, for example, begins to decline when interest rates increase on the market, or vice versa, if interest rates decrease and bond prices rise.
Yield Curve types
Normal yield curve. A normal, also known as up-sloped, demonstrates the fact that long-term bond yields will continue to rise during intervals of economic expansion. It is the curve where bonds with a longer maturity have a higher yield compared to bonds with a shorter maturity due to time risks.
For example, a yield of a 2-year bond is 1%, a yield of a 5-year bond is 1.8%, a yield of a 10-year bond is 2.5%, a yield of a 15-year bond has a level of 3.0%, and a twenty-year one has a yield of 3.5%. These points will be connected on a graph in this type of yield curve, that looks like an increasing convex line approaching some fixed value.
A normal yield curve tells about the stability of economic conditions, and the natural economic cycle is accompanied by the predominance of such a curve. This shape of the curve is fully consistent with the normal processes of economic development and reflects the growing risks of a temporary nature.
A steep yield curve means upcoming economic increase, but in this variant of the economic situation, there is an increase in inflationary risks, which is reflected in the expectations of an increase in the interest rate in the future. Accordingly, the assessment of the risks of holders of long-term debt securities requires an increase in yield to the theoretical average value. Moreover, this growth slows down with an increase in the maturity.
Inverted yield curve. An inverted yield curve slopes downward and implies that short-term interest rates are higher than long-term ones. This type of yield curve occurs during intervals of economic recession, when markets wait for a decrease in the yield of a bond with a longer maturity. An inverted yield curve is quite rare, despite this, it clearly signals a serious slowdown in the economy and warns of an upcoming recession. During an economic decline, investors looking for safe investments try to move into defensive assets, usually buying these long-term bonds instead of short-term ones, raising the price of longer bonds and lowering their yields.
The inverse curve on the initial segment looks like the exact opposite of the normal one, having a concave shape and showing a smooth decline. As the maturity increases, the curve can either maintain a monotonous fall with decreasing speed, or continue the transition to a horizontal or segment showing a slow increase. Significant yields on issues of debt securities with minimal maturities indicate a high level of short-term inflationary risks. In the future, the curve stabilizes or begins to rise, as issuers and investors factor in the return of rates to pre-crisis levels or the transition to a cycle of their increase.
Flat yield curve. A flat yield curve means the same yield over all maturities. In this type of yield curve, the shorter-term and longer-term yields are very close to each other. There is little difference in yield to maturity between shorter-term and longer-term bonds. For example, a 2-year bond may have a yield of 6%, a 5-year bond 6.1%, a 10-year bond 6%, and a 20-year bond 6.05%.
Such a bond yield curve takes the form of a line parallel to the maturity axis or with a slight decline or rise. This form of the yield curve is considered as intermediate, it can be formed during the transition from normal to inverse or reverse.
The first situation of appearing this curve is the eve of a crisis or a recession beginning, when inflationary risks are so high that an increase in short-term rates on debt securities is required. At the same time, long-term parameters remain unchanged. The normal yield curve starts to change into an inverse one.
And the second scenario appears in the later stages of a recession and early in the growth phase of the business cycle, when quantitative easing programs are in place. At the same time, short-term rates remain unchanged, while long-term securities require a downward adjustment. There is a transition from the reverse curve to the normal one. Some intermediate maturities may have slightly higher yields, so there is a slight hump on the flat curve. These humps can usually be attributed to medium-term maturities, from 6 months to 2 years.
A flat yield curve indicates uncertainty in the economy, such as periods of waiting for increasing of interest rates by the Central bank, or at the end of a period of high economic growth that leads to inflation and to expectations of its slowdown.
