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What Is The 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.
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- A yield curve graphically represents the yield expected from a bond investment over various maturity periods. The maturity term is plotted on X-axis, while the yield rate or interest rate is plotted on the Y-axis.
- The slopes as formed help analysts and investors understand the performance of the short-term and long-term investments, compare them, and accordingly make wiser investment decisions.
- Normal, steep, inverted, humped, and flat are the types of yield curves differentiated per the shape derived after plotting the figures on the graph.
- Such curves are linked to US Treasury securities in the United States.
Yield Curve Explained
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.
Types of Yield Curve
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.
Formula
When plotting the figures on the graph to prepare a yield curve chart, the following formula serves useful:
Example
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.
| Yield (%) | Maturity Term (months) |
|---|---|
| 0.2 | 1 |
| 0.5 | 5 |
| 1.5 | 15 |
| 2 | 25 |
| 2.5 | 30 |
Graph
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.
Frequently Asked Questions (FAQs)
These curves can either move up and form a normal curve or slope downward, leading to an inverted curve. When it goes upwards, it is indicative of a growing economy and stable security market. On the contrary, when the slope moves downward, it indicates a deteriorating economy. When medium-term investments do better than short-term and long-term maturities, a hump is formed.
A flat curve depicts the same yields throughout the maturities taken into consideration. On the contrary, a steep curve is similar to a normal curve. However, the only difference is that these curves indicate a broader difference in returns for short-term and long-term investments.
These curves invert when the short-term interest rates are better than the long-term yields. The graph indicates a bearish market, which signifies a diminishing economy for a prolonged period, likely to cause a recession.
While yield curves are all about US Treasury securities, these are also connected to the bond market. As a result, such curves also help detect the bond yields applicable over different maturity terms. Therefore, the investors compare the yields for their short-term and long-term investments and get an opportunity to prepare accordingly.
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