The yield curve comes up on
the financial news a lot.
But what is it?
Simply put, the yield curve is a graph
that measures the yields of short- and
long-term bonds and other fixed income
products of the same credit quality.
Recall that a yield is the
return on an investment.
For bonds, it’s calculated by dividing
the coupon rate by the market price.
When these are plotted over
time, we get a yield curve.
And it comes in three shapes.
When the curve is sloping upward,
it's considered normal.
It means that the yield
of shorter-term investments is lower than
the yield of longer-term investments.
For example, a one-year bond may yield a 2% return
while a 10-year bond may yield an 8% return.
And this is typically the shape of the curve.
It means that investors think the economy
will keep growing, and that
interest rates will keep rising.
They don’t want to lock in their money
long-term if more profitable yields are
on the horizon, so demand for long-term
bonds goes down, along with their yield.
At the same time, demand for short-term bonds
goes up, causing short-term yields to go down.
When the yield curve is inverted, it means
that the yield of shorter-term investments
is higher than the yield of longer-term ones.
For example, a one-year bond may yield an 8%
return while a 10-year bond may yield a 2% return.
This may happen when investors become pessimistic,
believing that inflation and
interest rates may go down.
They want to lock in current long-term interest
rates before they fall, causing a rise in
demand that pushes long-term yields down.
At the same time, demand for short-term bonds
drops, causing their yield to rise.
The third possible shape is a flat
yield curve – when the yield of short and
longer-term investments is roughly equal.
This can happen during a transition from a
normal to an inverted curve or vice versa.
It means investors aren't sure
which way yields will go next.
So how is this information helpful
to a fixed income investor?
Knowing the shape of the yield curve can help
investors decide how to allocate investments.
For example, if they expect interest rates
to rise, they may consider not to tie up all
their money in one long-term bond, given that new
bonds with higher prices are likely to be issued.
Of course, there are many ways to navigate fixed
income investing with the help of the yield curve,
and this is just one example to get you started.
For more information, check out our
video on how interest rates affect bonds.
Have more questions about income investing?
See our schedule of upcoming Webinars and
Master Classes for instructor-led content and
live insights from industry guest speakers.
