The yield curve: what it is and how it works

The yield curve is a graph that plots the time (from the shortest to longest maturity date) on the horizontal access and the return on the vertical access. It is used to show the relationship between yield and maturity.

Yield curves work best when you plot different maturity dates for the same type of bond, which means the only major difference between securities is their maturity date. For example, a yield curve could represent maturities and corresponding yields for treasury bonds, corporate bonds with top credit scores, municipal bonds of a particular state, or any other type of bond.

By comparing the yields of similar bonds, but with different maturities, we can generate a graph that shows how the yields change as the maturity date gets longer. (see examples below)

On the horizontal axis of the yield curve, we have the maturity period ranging from 6 months to 30 years. On the Y axis of the yield curve, we have the yield to maturity go from 0 to as high a percentage as needed to incorporate the returns of all plotted maturities.

Types of yield curves

The normal yield curve

Normally, the yield curve slopes upward, showing that, all other things being equal, a bond with a longer maturity yields a higher yield than the same bond with a shorter maturity. From the Great Depression until today, the yield curve has spent most of its time in the form of an ascending normal curve.

Why is this the normal situation? Generally speaking, individuals and institutions prefer to lend money for shorter periods rather than for longer periods. The risk that the lender will need the funds or that the borrower will be unable to pay increases over time. Another way of saying this is that the longer the term of the loan or obligation, the more likely it is that something unexpected will happen. To offset the additional risks associated with lending money for longer periods of time, lenders typically charge a higher interest rate.

The steep yield curve

When investors expect interest rates to rise in the future, it makes sense that they demand a higher rate of return when buying longer-term bonds. If longer-term bonds did not pay a higher interest rate in this situation, investors would simply buy shorter-term bonds, in the hope that when the bonds matured, they would be able to get a higher return on the next purchase. Often when the economy comes out of a recession, expectations of future interest rates will rise. Indeed, economic recoveries are normally accompanied by companies’ willingness to borrow more (to invest), which increases the demand for money, exerting upward pressure on interest rates. This causes the yield curve to steepen as you can see in the graph below:

The flat yield curve

The yield curve is flat when the yields of all maturities are close to each other. This happens when inflation expectations have fallen to the point where investors do not demand any premium to tie up their money for longer periods of time. As with the inverted yield curve, when the yield curve goes from normal to flat, it is usually a sign of an impending or ongoing economic downturn.

flat yield curve

The bumpy yield curve

The yield curve is bumpy when short and long term rates are closer to each other than with medium term rates. This usually happens when there is either an increase in demand or a decrease in the supply of longer-term bonds. In recent years, the demand for 30-year T-bills, for example, has grown more sharply than that of 20-year T-bills, which has often resulted in the yield curve on T-bills often shifting. bumpy shape.

bumpy yield curve

The inverted yield curve

The yield curve reverses when long-term rates are actually lower than short-term interest rates. This rarely happens, but when it does, it is one of the surest signs of an impending economic downturn, as investors anticipate less future demand for money and therefore lower interest rates. .

inverted yield curve

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