Yield Curve Risk

Yield curve risk is a type of risk arising from negative movements of market rates that are somehow connected with investing in fixed income instruments. Changes in market yields affect the price of an instrument with a fixed income and determine yield curve risk for an investor. As yields or interest rates grow in the markets, prices of bonds drop, and vice versa. 

More about Yield Curve Risk

The yield curve is an essential analysis tool for the investor, forming an idea of the short-term interest rates movement and the situation of growth or recession in the economy.

A yield curve is a graphic image of the bond yields having the similar credit quality, but also maturity dates that differ from each other. It is a graphical tool that can show the degree of yield curve risk. The y-axis on the graph represents interest rates, while the x-axis represents the increasing length of time.

A normal yield curve goes upward from left to right, which is due to the fact that the short-term bond yield is at the level below the long-term ones. An inverse connection exists between interest rates and bond prices, with an increase of the interest rate, the bond price decreases, and vice versa. Accordingly, with transformation of interest rates, the yield curve shifts, introducing a risk to the investor, which is called yield curve risk.

Yield curve risk is related to the yield curve flattening or, on the contrary, increasing its steepness, which is associated with a change in the yield of the bonds under consideration that have different maturities. In the case of a shift of the yield curve, the price of the bond will be revalued relative to its original cost, which was determined using the initial yield curve, so the price will change.

Investors who own interest-rate investments are at yield curve risk one way or the other. An investor's selection of specified assets for his portfolio, taking into account the expectation of interest rates changing, which will affect this portfolio in a certain way, will allow him to hedge against the yield curve risk.

An investor who is able to forecast the future yield curve movement and shift of it can use this situation to benefit, as the yield curve changes depend on risk premiums and waiting for upcoming interest rates. Purchasing exchange-traded funds (ETFs), further shifts in the yield curve are used for short-term investors to satisfy their own interests and to decrease yield curve risk in some extent.

Yield Curve Risk types

There are three types of curves that can demonstrate an investor the degree of yield curve risk.

Flattening yield curve. The yield curve smooths out as interest rates get closer. A flattening yield curve is the spread reduction of the yield of long and short-term interest rates, leading to a change in the price of a bond. In the case of a short-term bond with maturity in 3 years and downward 3-year yield, prices will grow. 

Suppose the following input parameters. The Treasury yield on a 2-year note is 1.11 percent and a 30-year instrument with a 3.6% yield. If the yield on the note decreased to 0.9%, and on the bond to 3.2%, the yield spread would be narrowed to 230 from the level of 250 bps. 

There is an indicator of a weak economy and signals the fact that inflation and rates will remain low for some time to come. Markets are in anticipation of an upturn in the economy, and the ability of financial institutions to lend is at a fairly low level.

Steepening yield curve. An indication of the widening range between long- and short-term rates is the fact that the slope of the yield curve has become steeper. The increase of yields on  bonds that are long-term is faster than on short-term. Accordingly, in comparison with instruments which are considered to be short-term, prices for long-term ones will drop. 

A steepening yield curve is generally an indicator of a stronger economy, rising inflationary expectations, and upcoming rising interest rates because of that. If the chart demonstrates a steepening direction, borrowing money by financial institutions occurs at interest rates with lower values and lending it at higher ones.

A 2-year note, which has a yield of 1.5%, and a 20-year investment with a yield of 3.5% are good examples of this curve type. With both Treasury yields rising in a month to 1.55% in the first case and 3.65% in the second, the spread will expand in basis points (200 - the previous level; 210 - the current one). 

Inverted yield curve. In cases, where the return on long-term instruments is lower than on short-term ones, the graph takes the inverted form. An inverted yield curve shows that investor expectations are tied to interest rates with lower values and inflation rates.