The yield curve is a visual representation of how interest rates of various bonds change at different maturities. The curve is a snapshot of how much bond investors can earn from interest at different maturity dates. If used correctly, a yield curve can show investors their potential returns and help inform their investment strategy. It can also foresight the state of the economy. In terms of the latter, the yield curve can mirror what direction the market thinks the Fed interest rates will move in.
Yield curves can apply to various types of bonds such as U.S. treasuries, municipal bonds, or corporate bonds to name a few. In most contexts such as in news headlines, the yield curve is referring to U.S. treasury bonds.
How A Yield Curve Works
Although the nature of bonds vary depending on what type of bond you invest in, the fundamentals are the same. You lend money to a government entity or corporation for a set period of time – 20 or 30 years, for example. The organization you lend the money to pays you coupons or recurring fixed interest payments for the duration of the loan. When the end of the loan period comes-also known as a bond’s maturity-you get the original amount you lent them back. You also would have gotten regular fixed interest payments throughout the duration of the loan.
To understand what a yield curve is, you must first have an understanding of what a yield is. A bond’s yield tells you how much interest an investor can earn over a period of time and is expressed as a percentage. Keep in mind that yield factors in the changing price of bonds sold on the secondary market. The secondary market is where investors can buy and sell bonds that have already been issued by the original issuer. That said, as market prices of a bond change, so does the yield.
A yield curve shows you how a bond’s interest rate changes with different maturity dates and is plotted on an X/Y axis graph. For instance, the Y axis may have the yield percentages while the X axis has the various dates until maturity. An investor can use the graph to compare yields at different points of maturity. Likewise, they can use it to make predictions about the economy, which can inform their investment choices.
Types of Yield Curves
There are four different types of yield curves and they all give a different picture of what’s happening in the economy.
Positive Yield Curve
When a yield is positive, investors expect the economy to be growing at a normal pace. The curve slopes upwards from left to right, indicating that an investor gets higher yields the longer they hold bonds. In most cases, long-term bonds carry higher risk, so investors are rewarded by receiving higher yields. The longer you lend money for, the higher the risk because changes could occur in the economy that affect you getting your money back. The shorter the maturity, the lower the yields. Reason being, when you borrow money for shorter periods, you’re more likely to get your money back and are taking less risk. With less risk often comes lower reward.
That said, disruptions in the economy can lead to this curve not being so straightforward.
Inverted Yield Curve
When yield curves are inverted, they are the opposite of basic or positive yield curves. Bonds with shorter maturity offer higher interest rates, whereas bonds with longer maturity dates offer lower rates. This happens because investors fear that inflation rates are going to continue decreasing and the current rate is the best that they’ll get. In other words, they lock in a lower interest rate because they don’t believe it will increase due to economic circumstances.
It isn’t uncommon for an inverted yield curve to indicate a brewing recession. The slope usually trends down to the right with an inverted yield curve.
Steep Yield Curve
When investors expect higher short-term rates in the future, it’s expressed as a steep yield curve. If the curve is steepening, it can mean investors are expecting higher inflation.
Flat Curve
The slope rises and then is flat on this curve because the difference between long-term and short-term maturities decreases. What this could mean for the economy is that there’s an expectation that the Fed will raise interest rates, the economy will slow down, and investors expect short-term rates to fall.
