Yield Curve

The yield curve is the measure of the yield that investors can expect to receive with respect to the interest rates against the amount they lend to an entity. While plotting on the graph, the X-axis reflects the term to maturity, and the Y-axis depicts the expected yield. In the United States, the yield curve is mostly prepared to assess the performance of the US Treasury securities.

The yield curve helps traders understand the bond market well. For example, when the interest rates are studied against their tenor, it helps investors and analysts assess the market concerning how much investors would earn from their investments in short-term and long-term bonds.

The yield curve reflects the effect of market fluctuations on the interest rates associated with the bonds investors invest in. As a result, they get an opportunity to compare the market and make decisions practically, considering the working of the market. As a result, the analysts can quickly identify the direction of movement of the market and help investors make wiser investment decisions.

In the US, the yield curve is linked to Treasury securities, through which investors lend money to the government. The latter, in return, promises to pay back the principal amount within a given period, along with the interest income applicable. The curve derived when the interest rates (Y-axis) are plotted against the maturity term (X-axis) allows investors to detect the price movements and determine the expected returns at maturity.

The interest rate applicable for the returns is fixed and is known as a coupon rate. However, the yield keeps changing even when the interest rate remains constant. This is because Treasuries' price constantly fluctuates in the trading market.

Whether it is a treasury or bond yield curve, plotting the interest rate value and the maturity term on the graph brings investors to multiple forms of yield curves, exhibiting different shapes. These include:

#1 - Normal Curve

A normal yield curve shows an increase in the yields with maturity. Such curves indicate a healthy economy and an actively functioning market. This helps investors understand that if they preserve the investment for longer-term, they are likely to reap more profits with time.

#2 - Steep Curve

It looks similar to a normal curve with slopes going up. However, it is steeper than the normal ones. The formation of this type of graph indicates that the market conditions would be better with time. As a result, long-term investments are likely to receive better profits than short-term investments, making a significant difference in the long-term and short-term returns.

#3 - Inverted Curve

This curve is formed with slopes moving down to the right instead of going up, indicating a recession or unstable market conditions. The inverted graph is derived when the rates for short-term investments are more than those for long-term securities. As a result, when analysts and investors derive an inverted yield curve, they know it's an indication of a bearish market.

#4 - Humped Curve

When the medium-term investment is likely to yield more than expected from both short-term and long-term securities, a humped curve emerges. Such curves are rare but indicate a slow and inactive economy.

#5 - Flat Curve

A flat curve appears when the securities with short-term, medium-term, and long-term securities are likely to yield the same returns. It indicates an uncertain economic condition.

When plotting the figures on the graph to prepare a yield curve chart, the following formula serves useful:

Let us try and create a treasury yield curve. The X-axis begins with the interest rates or yields (%) for bills of shorter-term maturity and moves above with the securities with maturity terms ranging from a couple of days to one year, two years, and so on to the right. First, however, the maturity period is plotted on the Y-axis.

The graph formed based on the above data is a normal curve. Therefore, it signifies an optimistic market, i.e., better returns for investors who have invested in long-term investments.