Yield Curve Risk

Yield Curve Risk refers to the threat that interest rates on similar-quality bonds with different maturities may change, impacting returns. The yield curve, a graph of bond yields over time, poses the risk of inversion, where long-term rates fall below short-term rates, signaling economic concerns.

It is significant as it highlights the uncertainty surrounding future interest rate movements, affecting bond prices and investment returns. An inverted yield curve, where long-term rates fall below short-term rates, signals potential economic downturns. Investors use it to assess market conditions, adjust investment strategies, and hedge against interest rate fluctuations, impacting portfolio performance and risk management decisions.

• Yield curve risk refers to the risk associated with changes in the shape or slope of the yield curve. This risk arises from fluctuations in interest rates, which affect the relative prices of bonds with different maturities.
• As interest rates fluctuate, investors may face diminished yields, resulting in a lower rate of return and prompting adjustments to their existing investments. This inherent risk in fixed-income investing is known as yield curve risk. Additionally, shifts in the yield curve offer investors insights into potential future economic growth.
• Yield curve risk focuses on changes in bond prices due to shifts in the yield curve. In contrast, basis risk pertains to the mismatch between price movements of the underlying asset and its derivative used for hedging, which is inherent in hedging strategies.

Yield curve risk arises from the dynamic relationship between bond prices and interest rates. Initially, when a bond is issued, its interest rate, or coupon rate, is fixed for its maturity period. However, as new bonds are issued with different interest rates, the yield curve, which represents the relationship between bond yields and their respective maturities, can shift.

For instance, if newly issued bonds offer higher interest rates, the yield curve may steepen, making long-term investments comparatively less attractive than short-term ones. Conversely, if new bonds carry lower rates, the yield curve might flatten or even invert, with long-term rates dropping below short-term rates, signaling economic uncertainty or recessionary pressures.

This shift in the yield curve impacts bond prices inversely. As interest rates rise, existing bond prices decrease to align with the higher yields of newly issued bonds, potentially causing losses for bondholders who sell before maturity. Conversely, falling interest rates can lead to capital gains for bondholders as existing bond prices increase to match the lower yields of newer issues.

Investors facing yield curve risk may choose to sell their bonds prematurely if they anticipate better opportunities elsewhere, potentially in investments offering higher yields or better prospects for capital appreciation. However, this decision depends on various factors, including the investor's risk tolerance, investment objectives, and market conditions.

Let us look at the yield risk curve examples to understand the concept better- 

Example #1

Suppose John purchased a 10-year Treasury bond in January 2022 with a fixed interest rate of 2%. At that time, the yield curve was moving upward, showing greater yields for longer-term bonds.

However, by January 2024, the Federal Reserve had raised interest rates due to concerns about inflation. As a result, newly issued 10-year Treasury bonds were offering a higher interest rate of 3%, causing the yield curve to steepen.

Now, despite John's bond having a fixed rate of 2%, its value had decreased in the secondary market because investors could buy newer bonds with higher yields. If John decided to sell his bond before maturity, he would incur a loss since its price had declined due to the change in interest rates.

This example illustrates how yield curve risk can impact bondholders. Changes in the yield curve can affect bond prices, leading to potential gains or losses for investors depending on their timing and the direction of interest rate movements.

Example #2

The recent surge in US 10-year Treasury yields, reaching as high as 4.88% in early October 2023, has prompted significant concern about its impact on financial conditions. This rapid increase, amounting to approximately 100 basis points since July, has led to a tightening in financial conditions within the US economy. The potential negative consequences of such a swift movement cannot be overlooked, as evidenced by the turmoil observed in the US banking sector in March 2023.

In response to these developments, Federal Reserve officials have hinted at a potential shift in monetary policy stance. Lorie Logan, President of the Federal Reserve Bank of Dallas, Texas, suggested on October 9 that the surge in long-term Treasury yields might alleviate the need for further increases in the Fed's benchmark interest rate. This sentiment was echoed by Fed Vice Chair Philip Jefferson, who noted that the tightening of financial conditions and the sharp rise in long-term real yields were effectively performing some of the tightening work on behalf of the Fed.

These remarks, coupled with geopolitical events in the Middle East, contributed to a notable reversal in US bond yields, with 10-year yields falling by as much as 18 basis points in a single day, marking the most significant one-day decline since March.

The differences between yield curve risk and basis risk are as follows:

This article has been a guide to what is Yield Curve Risk. Here, we explain the concept along with its examples and differences with basis risk. You may also find some useful articles here -

• Flat Yield Curve
• Bootstrapping Yield Curve
• Inverted Yield Curve