When discussing interest rates, it’s common to assume that all rates act identically. But in practice, rates on different bonds usually behave fairly differently from one another depending on their age. A yield curve, which is a graphical depiction of the yields offered for bonds of equivalent credit rating and various maturity dates, is a useful tool for quickly visualizing this disparity.
A yield curve can significantly affect the returns on your investment and is a tool for gauging bond investors’ attitudes toward risk. A yield curve may even be used to predict the economy’s direction if you know how it works and how to read it.
The range of bonds that a given yield curve covers are typically constrained by the type of bond it represents. The yield, most commonly referred to as “the yield curve,” represents the short, intermediate, and long-term rates of US Treasury securities. The Treasury yield curve is frequently used as a proxy for investor perception of the economy’s trajectory. However, a yield curve may also apply to other bond categories, such as the AAA Municipal yield curve, or it might reflect a more specific issuer’s market, like the GE or IBM yield curve.
What Is a Yield Curve?
A yield curve is a line that represents the yields of bonds with similar credit ratings but various maturities. The yield curve’s slope provides insight into potential future changes in interest rates and economic activity.
The three types of yield curves are flat, inverted, and normal.
How Does A Yield Curve Work?
A yield curve is used to predict changes in economic production and growth and serves as a benchmark for other types of debt on the market, such as mortgage rates or bank lending rates. The yield curve that is most usually mentioned contrasts US Treasury debt with terms of 3 months, two years, five years, ten years, and 30 years.
Due to the risks involved with time, a normal yield curve has longer maturity bonds paying out more than short-term bonds. An inverted yield curve may indicate an approaching recession with greater short-term yields than long-term yields. The proximity of the shorter and longer-term rates on a flat or humped yield curve is another indicator of an ongoing economic transition.
Types of Yield Curves
Normal Yield Curve
Short-term bonds often have lower yields than longer-term bonds to reflect the lower risk to an investor’s money. The logic behind this is that the longer you commit funds, the more you ought to be compensated for it – or compensated for the chance you take that the borrower won’t repay you.
This is mirrored in the normal yield curve, which slopes upward from left to right on the graph as maturities extend and yields increase. This kind of yield curve is typically seen when bond investors expect steady economic growth without considerable changes in the rate of inflation or severe disruptions in the supply of credit.
Inverted Yield Curve
An inverted yield curve slopes downward, indicating that short-term interest rates are higher than long-term rates. A yield curve like this is indicative of an economic downturn when investors anticipate more declines in rates on bonds with longer maturities. In addition, during a downturn in the economy, buyers looking for secure assets prefer to buy these longer-dated bonds over short-dated ones, driving up the price of long bonds and lowering their return.
Flat Yield Curve
Similar yields across all maturities are indicative of a flat yield curve. There may be a few intermediate maturities with slightly higher yields, which result in a little hump along the flat curve. These barriers often affect mid-term maturities, especially those between six months and two years.
The term “flat” refers to the lack of significant variation in yield to maturity between shorter and longer-term bonds. A yield of 6% is possible for a 2-year bond, 6.1% for a 5-year bond, 6% for a 10-year bond, and 6.05% for a 20-year bond.
Types of Yield Curves
Yield Curve Usage
Investors use the yield curve to predict potential economic growth and use this knowledge to guide their investment choices. Investors might transfer their money info defensive assets that typically do well during recessionary periods, such as consumer staples if the bond yield curve suggests that an economic slowdown may be coming. Future inflation could be predicted if the yield curve accelerates. Investors could steer clear of long-term bonds if the yield decreases as prices rise.
Takeaways
- A yield curve is a useful tool for quickly visualizing this disparity.
- The three types of yield curves are flat, inverted, and normal.
- Short-term bonds often have lower yields than longer-term bonds to reflect the lower risk to an investor’s money.
- An inverted yield curve slopes downward, indicating that short-term interest rates are higher than long-term rates.
- The term “flat” refers to the lack of significant variation in yield to maturity between shorter and longer-term bonds.
