Understanding the Yield Curve
Have you ever heard the term “yield curve”? If you haven’t, you’re not alone. But you might be interested to know that the yield curve is an important tool for investors.
Why the Treasury Market
Although a yield curve can be determined for the spreads between maturities of bonds for any sector, the term “yield curve” is most often used to refer to the curve determined by the U.S. Treasury Bill market. Risk-free discount rates can be derived from Treasuries to match most maturities. This information can be used as a benchmark to determine the value of other investments, and whether or not their returns are worth their risks.
Treasury securities are debt instruments that have a face value, market price and maturity date. Upon maturity, the bond pays the holder the face value. Longer-term bonds also have a coupon value and pay interest over the life of the bond. To put it simply, the sum of the interest payments and the final face value payment, divided by the price, make up an investor’s return or yield.
Although Treasury securities have fixed face values, maturities and coupon rates, their prices may vary because they are actively traded. Price changes may occur for a number of reasons. As the price changes, so does the yield.
The Yield Curve
The U.S. Treasury offers bonds with many maturities, varying from one year (a T-Bill) to 30 years. The yield curve plots the maturities and yields for all of these securities. Generally, the longer the time until maturity, the more risk a security holder bears, and therefore, the higher a return they expect. However, as market forces adjust the price for various securities, this may not be the case.
What the Shapes Mean
The yield curve’s slope or “shape” always fits one of three descriptions:
- Normal: A normal slope is positive (lower on the left, higher on the right). This shape shows that longer-term securities have a higher yield than short-term securities, as is generally expected. This shape generally indicates that investors expect the economy to grow.
- Flat: A flat yield curve means that there isn’t much of a reward for holding longer-term securities. Common interpretations of a flat yield curve include investors expecting a rise in short-term interest rates, or a decrease in inflation.
- Inverted: When long-term bonds are in high demand, raising their price and lowering their yield, it can cause an inverted yield curve (higher on the left than on the right). Inverted yield curves have often preceded major recessions by months or years and are frequently viewed as a serious economic warning indicator.
These shapes and their interpretations are further explored by: the Expectations Theory, Liquidity Preference Hypothesis and the Segmented Market Hypothesis. Proper treatments of these concepts is beyond the scope of this article, but can be easily found with a few quick internet searches.
As you plan your portfolio, remember to keep an eye on the yield curve and the spread between short- and long-term Treasury securities. If the spread has been flattening for months, it might be a good idea to shift your allocation to steadier investments. If it’s growing, that’s generally a sign that you can feel good about equity investments. Just remember, all indicators should be taken with a grain of salt!