Bonds 102: Understanding the Yield Curve
What you will learn
- What yield is
- What a yield curve is
- What the shape of the yield curve can tell us
- How investors can use the yield curve
What is yield?
Before investors can understand the concept of a yield curve, they must first be comfortable with the term “yield,” which simply means the annual return of an investment. When it comes to bonds, the yield is based on the purchase price of the bond along with the coupon payments received.
Bond investors often use a measure of yield called “yield to maturity” to assess one bond against another. Yield to maturity reflects the total return an investor receives by holding the bond until maturity – that is, it includes all interest payments as well as any appreciation or depreciation in the price of the bond.
What is a yield curve?
The yield curve is essentially a line graph that shows the relationship between yields to maturity and time to maturity for a number of bonds.
The bonds plotted on a yield curve need to be of the same asset class and credit quality. This is important because it means the yield curve shows the difference in yield from one bond to another according solely to each bond’s maturity. The relationship between yield and maturity is known as the “term structure” of interest rates.
A yield curve can be created for any type of bond. The most widely used is the U.S. Treasury bond yield curve because these types of bonds have no perceived credit risk (because of their government guarantee) and represent a wide range of maturities from three months to 30 years.
Let’s look at an example. The chart below shows an illustrative yield curve for U.S. Government Bonds. The plotted line begins with the bond that has the shortest maturity – in this case, one month. It then extends out over time, showing bonds with maturity of up to 30 years. As you can see in the chart, the yield for a 3-year bond is 2.0%, while the yield on a 10-year bond is 2.4%.
Illustrative Government Bonds Yield Curve
What does the shape of the yield curve tell us?
The shape of the yield curve tells us whether interest rates are expected to rise or fall in the future. For example, an upward slope indicates that market participants believe rates are likely to go up.
The slope of the curve can be a good indicator of the economic climate because it tells us what investors think about future rates and, hence, the economic outlook.
Below are three common yield curve shapes with a description of what they mean.
Normal yield curve
The normal shape of the yield curve is upward sloping, from left to right. This type of yield curve indicates that bond yields are higher on longer maturity bonds.
Typically, this type of yield curve is seen during periods of economic expansion when the economy is growing.
In this environment, investors demand higher yields on longer-term bonds as compensation for inflation and future rate rises.
Flat yield curve
Flat yield curves are seen when the economy is transitioning from expansion to slowdown, and vice versa.
Most often, a flat yield curve is seen when central banks raise interest rates to constrain a rapidly growing economy. In this instance, short term rates rise to reflect rate hikes, while long-term rates fall as inflation expectations become more moderate.
Inverted yield curve
Sometimes the yield curve inverts to a downward sloping shape, indicating that bond yields are lower on longer maturity bonds.
This shape is not common and is typically seen during periods of recession when interest rates and inflation are low or declining.
Historically, the yield curve moves into an inverted position about 12 to 18 months before recession starts.
How can investors use the yield curve?
For those looking to invest in bonds, the yield curve is a useful tool for comparing the different fixed income securities available. The yield curve for U.S. Treasury bonds is often used because it has no perceived credit risk. This means other bonds that have some form of risk can be benchmarked against it.
For example, a 3-year corporate bond might be priced to yield 0.5% above a 3-year U.S. Treasury bond, because of differences in perceived credit risk.
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