Education

Bonds 102: Understanding the Yield Curve

The term “yield curve” is frequently used by investors and commentators when discussing the outlook for bonds, markets, and the economy. Investors can use the yield curve as a tool to assess general economic conditions to help guide their investment decisions.

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

The figure is a line graph showing a regular-shaped yield curve for U.S. government bonds. The Y-axis represents yield, and the X-axis shows years to maturity from one to 14 years. The plotted line begins with the bond that has the shortest maturity, one year, with a yield of about 1.75%. As the curve extends out over time, yields increase. The chart shows how the yield for a three-year bond is 2.0%, while the yield on a 10-year bond is 2.4%. The curve flattens out as years to maturity increase: The yield for a bond 14 years to maturity pays 2.5%, not much more than what is paid on the 10-year bond.
For Illustrative Purposes Only

A simple line graph shows the normal shape of the yield curve, which is upward sloping from left to right, concave downward. This type of yield curve indicates that bond yields are higher on longer maturity bonds. On the graph, the Y-axis represents yield, and the X-axis shows years to maturity. Bonds with short maturity pay the lowest yield, and as the curve arcs upward, its slope becomes less steep, flattening out for longer-dated bonds.

A line graph shows a flat yield curve, with a straight horizontal line positioned halfway up the graph. On the graph, the Y-axis represents yield, and the X-axis shows years to maturity. The yield is the same across all maturities. Flat yield curves are seen when the economy is transitioning from expansion to slowdown, and vice versa.

A simple line graph shows the shape of an inverted yield curve, which is downward sloping from left to right, concave upward. On the graph, the Y-axis represents yield, and the X-axis shows years to maturity. This type of yield curve indicates that bond yields are higher on shorter maturity bonds. Bonds with short maturity pay the highest yield. As the curve arcs downward, its slope becomes less steep, flattening out for longer-dated bonds.

Glossary of Key Investment Terms