What Is a Yield Curve?
A yield curve is a line that plots yields, or interest rates, of bonds that have equal credit quality but differing maturity dates. The slope of the yield curve can predict future interest rate changes and economic activity.
There are three main yield curve shapes: normal upward-sloping curve, inverted downward-sloping curve, and flat.
Key Takeaways
- Yield curves plot interest rates of bonds of equal credit and different maturities.
- Three types of yield curves include normal, inverted, and flat.
- Normal curves point to economic expansion, and downward-sloping curves point to economic recession.
- Yield curve rates are published on the U.S. Department of the Treasury’s website each trading day.
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Using a Yield Curve
A yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and can predict changes in economic output and growth. It is easy to build an Excel sheet to chart a yield curve and get a visual representation of the curve.
The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. Yield curve rates are available at the Treasury's interest rate websites by 6:00 p.m. ET each trading day.
Investors can use the yield curve to make predictions about the economy to make investment decisions.
Types of Yield Curves
Normal Yield Curve
A normal yield curve shows low yields for shorter-maturity bonds and thenincreases for bonds with a longer maturity, sloping upwards. This curve indicates yields on longer-term bonds continue to rise, responding to periods of economic expansion.
As yields increase over time, the points on the curve exhibit the shape of an upward-sloping curve. Sample yields on the curve may include a two-year bond that offers a yield of 1%, a five-year bond that offers a yield of 1.8%, a 10-year bond that offers a yield of 2.5%, a 15-year bond offers a yield of 3.0% and a 20-year bond that offers a yield of 3.5%.
Some bond investors will use a roll-down return strategy and sell a bond as it moves toward its maturity date. Also known as riding the curve, the stragety works in a stable rate environment as the bond's yield falls and the price rises. Investors hope to capture profit from the rise in bond price.
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A normal yield curve implies stable economic conditions and a normaleconomic cycle. A steep yield curve implies strong economic growth, with conditions often accompanied by higher inflation and higher interest rates.
Inverted Yield Curve
An inverted yield curve slopes downward, with short-term interest rates exceeding long-term rates. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to trend lower in the future. In an economic downturn, investors seeking safe investments tend to purchase longer-dated bonds over short-dated bonds, bidding up the price of longer bonds and driving down their yield.
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An inverted yield curve is rare but suggests a severe economic slowdown. Historically,the impact of an inverted yield curvehas been a warning of recession.
Flat Yield Curve
A flat yield curve reflects similar yields across all maturities, implying an uncertain economic situation. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve. These humps are usually for mid-term maturities, six months to two years.
The curve shows little difference in yield to maturity among shorter and longer-term bonds. A two-year bond may offer a yield of 6%, a five-year bond of 6.1%, a 10-year bond of 6%, and a 20-year bond of 6.05%. In times of high uncertainty, investors demand similar yields across all maturities.
What Is a U.S. Treasury Yield Curve?
The U.S. Treasury yield curve refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds. The chart shows the relationship between the interest rates and the maturities of U.S. Treasury fixed-income securities. The Treasury yield curve is also called the term structure of interest rates.
What Is Yield Curve Risk?
Yield curve risk refers to the risk investors of fixed-income instruments, such as bonds, experience from an adverse shift in interest rates. Yield curve risk stems from the fact that bond prices and interest rates have an inverse relationship to one another, as the price of bonds decreases when market interest rates increase and vice versa.
How Can Investors Use the Yield Curve?
Investors can use the yield curve to make predictions about the economy to make investment decisions. If the bond yield curve indicates an economic slowdown, investors might move their money into defensive assets that traditionally do well during a recession. If the yield curve becomes steep, this might signal future inflation. In this scenario, investors might avoid long-term bonds with a yield that will erode against increased prices.
The Bottom Line
There are three main yield curve shapes: normal upward-sloping curve, inverted downward-sloping curve, and flat. The slope of the yield curve predicts interest rate changes and economic activity. Investors can use the yield curve to make predictions about the economy to make investment decisions.
