Meaning of Yield Curve
The yield curve is a graphical representation of interest rates of different bonds having similar credit quality but different maturities. The x-axis represents the maturity, and the y-axis represents the interest rates. It tells how much you can expect if you lend money for a given period of time. It can also measure the economy’s direction and indicate future interest rates.
How Does a Yield Curve Work?
It gives a picture of the bond market at the moment in time. It shows the average yield of short, medium, and long-maturity bonds on one graph. Usually, short-term interest rates are lower than long-term interest rates. This is because investors expect a higher return for investing in long-term securities with a considerable amount of risk.
The difference in the interest rates of short-maturity bonds and long-maturity bonds is the risk premium that the investors expect for taking a risk. By looking at this curve, you can compare the interest rates of different bonds. By comparing, you can gauge whether long-term bonds’ yield is enough to compensate for the risk undertaken.
The higher the difference between the short and long-term interest rates, the steeper the curve. If the difference is less, the curve will be flatter, and you will not be willing to invest in long-maturity bonds as the return is lower.
Types of the Yield Curve
There are five types of yield curves that help predict the direction of the economy and interest rates.
Normal yield curve
This is an upward-sloping curve. It begins with short-term bonds with low yields and ends with high-yielding long-term bonds. The upward slope indicates economic expansion and that the economic conditions are healthy. In such a situation, investors would be willing to invest in more long-term bonds and take the additional risk for a higher return.
Steep yield curve
This is the same as a normal yield curve but has a steeper slope. The economic conditions are the same as the normal curve. But the investors expect the economy and market to have healthy market conditions for the long term, accompanied by higher interest rates and inflation. Hence, the difference between short- and long-term yields is bigger, leading to a steeper curve.
Inverted yield curve
This slopes downwards, indicating that short-term yields are higher than long-term yields. The downward slope indicates economic recession, where the long-term yields are expected to go further down. Another reason for the decline is an expectation of a fall in inflation. In such a situation, investors won’t be willing to invest in short-term bonds.
Flat yield curve
This indicates that the short-term and long-term yields are the same. A flat yield curve occurs during the transition from a normal to an inverted curve. It implies an uncertain economic situation.
Humped yield curve
A humped yield curve occurs when the medium-term securities yields are higher than long and short-term yields. It indicates slowing economic growth. This may lead to an inverted yield curve, but not always.
Importance of Yield Curve
This is a very useful tool for investors and analysts.
Predicting interest rates
It helps to predict future interest rates. If the curve slopes upward, the interest rates are expected to go up. This indicates that bond prices will fall, and investors will look for short-term bonds or other securities that are not sensitive to interest rate changes. Alternatively, if the curve slopes downward, the interest rates are expected to fall, and bond prices will go up.
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For financial intermediaries
This is very useful for financial intermediaries such as banks. Banks borrow money by short-selling term deposits and use the same for giving long-term loans. The difference between the interest rates is their profit. The higher the difference, the higher their profit. A rising curve indicates high profits, whereas a flattening curve indicates fewer profits.
Spotting underpriced and overpriced securities
In equilibrium, the yields of similar risk securities at different maturity levels will be on the yield curve. If any security is above or below the curve, then it is either underpriced or overpriced. If a bond is above the curve, it is underpriced, indicating a buy signal. This will drive the bond’s price upwards and yield down until it reaches the yield curve. Alternatively, if the bond is below the yield curve, it is overpriced, and investors will sell it till the prices go down and the yield increases.
A trade-off between maturity and yield
If, as an investor, you wish to alter your portfolio’s maturity, this curve shows the gain or loss you can expect due to the change. If the bond curve is upward-sloping, you can increase the portfolio’s maturity to increase the bond yield. However, the risk of capital loss also increases. As the bond curve flattens for long-term maturities, the incremental return for increasing maturity also reduces. This shows that increasing maturity beyond a point can lead to higher risk than a higher return.
Factors Affecting the Yield Curve
The following factors are –
- Inflation: A rising inflation is countered with an increase in interest rates to reduce the money supply. This leads to an increase in short-term interest rates.
- Interest rates: An increase in government securities‘ interest rates will make them more desirable. The prices of these securities will go up, leading to a fall in interest rates in the short term.
- Economic growth: Economic growth can lead to inflation. In such situations, investors will have more options to invest their capital as they are positive about long-term growth. The yields will increase, leading to a steep curve.
Recommended Read: Fixed vs Floating Interest Rates
Frequently Asked Questions
It helps in forecasting future interest rates and economic growth. A normal yield curve indicates a healthy economic situation, but an inverted curve would mean recession.
It helps determine the interest rates. If the curve is normal and upward-sloping, interest rates are expected to go up. Alternatively, interest rates are expected to go up if the curve is downward sloping.
When the interest rates rise, bond prices fall, and yields increase. This will make the yield curve steeper indicating economic growth.
Bond yields are a percentage of the price and interest. The yields rise when the prices fall. This is because bond prices and interest rates are inversely related. Rising yields indicate falling demand for that security. In other words, the investors are more inclined towards higher-risk, higher-yielding securities.