Yield Curve

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Definition: Yield Curve

Yield Curve

Quick Summary of Yield Curve

The yield curve shows the relationship between a bonds yield and maturity date.

Video Guide For Yield Curve

What is the dictionary definition of Yield Curve?

Dictionary Definition

The Yield Curve is a curve on a graph on which the yield on deposits or fixed-interest securities are plotted against the length of time they have to run until Maturity. The yield curve typically slopes upwards, indicating that investors anticipate receiving a premium for holding onto securities that have a long time to run.

A negative yield curve (down-sloping curve) may occur however, when the market expects falling interest rates or deflation.

A flat (or humped) yield curve usually expressive of uncertainty in the market.

Full Definition of Yield Curve

A yield curve is a plot of the yields of all bonds of the same quality, from lowest to highest maturity. The typical yield curve is based on the yield-maturity relationship of default-free US Treasury securities. There are three basic configurations for a yield curve, depending on interest rate levels and the general economic conditions. A positive yield curve shows short-term interest rates are lower than long-term interest rates. A flat yield curve results when short-term and long-term interest rates are about the same. A negative yield curve is seen when short-term interest rates are higher than long-term interest rates. The yield curve (especially the negative yield curve) can be a helpful tool in forecasting the future health of the economy.

In finance, it is a graph of the effective or real interest (the yield) of a security, usually a bond, against the length of time until all capital and interest has been paid back (the maturity). Yield curves are also called term structure of interest rates.

Yield curves offer meaningful insight if maturity is the only variable differing among the securities examined. Other properties, such as a bond’s credit rating or its call features, must be identical.

Fixed-income analysts, those who analyse bonds and related securities, use the yield curve to understand market conditions. Economists use it to understand economic conditions.

Yield curves are usually upward sloping and accelerating; the longer the maturity, the higher the yield. The usual explanation is that longer maturities entail greater risks for the investor, and so require higher yields. With longer maturities, more catastrophic events might occur that may impact the investment, hence the need for a risk premium. This explanation depends on the distant future being more uncertain than the near future, and the risk of future adverse events (such as default and higher short-term interest rates) being higher than the chance of future positive events (such as lower short-term interest rates).

The reverse, when short term rates are higher than long term rates, results in an inverted yield curve. Inverted yield curves have historically preceded economic depressions.

Yield curves carry an implicit forecast of future short-term interest rates: for example if the annual yield on a 10-year bond is 5%, and on an 11-year bond is 5.5%, then the implicit yield in year 11 is

1.05511/1.0510 – 1 = 10.6%

There are three main types of yield curve shapes:

  • Normal yield curve: A normal yield curve is one in which yields rise as maturity lengthens, indicating that investors expect the economy to grow in the future, accompanied by rising inflation.  The slope of a normal yield curve is positive.
  • Inverted yield curve: An inverted yield curve is one in which long-term yields fall below short-term yields. Under unusual circumstances, investors will settle for lower long-term yields now if they think the economy will likely slow or even decline in the future.
  • Flat (or humped) yield curve: A flat yield curve is one in which all maturities are very close to each other, while a humped curve is formed when shorter and longer-term maturities have similar yields, and medium-term yields are higher than those of the short-term and long-term.

The most important item in a yield curve is the spread, which is the difference between the interest rates paid on any two bonds in the curve. If a 30-year bond pays 6% while a 5-year bond pays 5%, the yield spread is 1%.The spread is a simple measurement by which to compare bonds, and gives us an indication of the risk premium for investing in one debt instrument over another.

Steep Yield Curves

When the yield curve is steep (when the interest rate spread is wide), this is a strong predictor of economic weakness. It often occurs when the Federal Reserve attempts to combat economic weakness by decreasing its overnight rate, which decreases borrowing costs and so stimulates lending, which is theoretically utilised to make purchases and stimulate the economy. The issue is that the low overnight rate raises inflationary fears among fixed-income dealers, as inflation reduces the value of future principal and interest payments on bonds. As a result of this anxiety, traders sell their longer-term bond holdings, which are more at danger of losing value due to inflation, lowering their prices and increasing their yields. These activities result in a wider interest rate spread, with a lower short-term rate and a higher yield on longer-term instruments — implying a steeper yield curve.

Flat Yield Curves

The converse can also occur. The Fed may opt to boost interest rates to cool a hot economy, as a higher rate restricts borrowing and hence dampens spending. This minimises the risk of long-term inflation, which encourages fixed-income traders to purchase longer-term bonds, rising their prices and decreasing their yields. The end consequence is a flatter yield curve, as short-term interest rates rise and long-term interest rates decline. When this reversal occurs more rapidly, the yield curve can invert, with short-term rates exceeding long-term rates. An inverted yield curve is a reasonable predictor of recession, as fixed-income traders anticipate a sluggish economy in the future, which supports their longer-term expectation of low interest rates. The inverted yield curve is not a perfect predictor of recessions, as it has forecasted multiple recessions that never materialised.

Synonyms For Yield Curve

efficiency curve
efficiency characteristics
rate curve
rate term structure

Related Phrases

Annual percentage yield
Average dividend yield
Bond equivalent yield
Capital gains yield
Convenience yield
Cost yield
Coupon equivalent yield
Current yield
Curve trader
Dividend yield
Dividend yield funds
Dividend yield stocks
Earnings yield
Effective annual yield
Equivalent bond yield
Equivalent taxable yield
Flat yield curve
Flattening of the yield curve
High yield
High yield bond
Indicated yield
Indifference curve
Inverted yield curve
J curve
Liquid yield option note
Negative yield curve
Nominal yield
Non parallel shift in the yield curve
Normal yield curve
Parallel shift in the yield curve
Positive yield curve
Potential average dividend yield
Pure yield pickup swap
Realized compound yield
Realized yield
Relative yield spread
Reoffering yield
Required yield
Riding the yield curve
Spot rate curve
Stated yield
Steepening of the yield curve
Stopping curve
Stopping curve refunding rate
Theoretical spot rate curve
Weighted average portfolio yield
Yield burning
Yield curve option pricing models
Yield curve strategies
Yield ratio
Yield spread strategies
Yield to call
Yield to call, option or event date
Yield to maturity
Yield to worst
Zero curve

Yield Curve FAQ's

What Is A Yield Curve?

A graph of the term structure of interest rates that depicts the relationship between the yield to maturity of a security (y-axis) and the time to maturity (x-axis); it shows the pattern of interest rates on securities of equal quality and different maturity.

A graph showing, for securities that all expose the investor to the same credit risk, the relationship at a given point in time between yield and current maturity. Yield curves are typically drawn using yields on governments of various maturities. It is also called the term-structure of interest rates. Typically the yield curve rises with maturity.

A graphic representation of a curve that shows Interest Rates at a specific point for all securities having equal risk but different maturity dates. Usually, government securities are used to construct such curves. See also: Flat Yield Curve; Inverted Yield Curve; Normal Yield Curve.

The graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities. Related: Term structure of interest rates. Harvey (1991) finds that the inversions of the yield curve (short-term rates greater than long-term rates) have preceded the last five U.S. recessions. The yield curve can accurately forecast the turning points of the business cycle.

Refers to the graghical or tabular representation of interest rates across different maturities. The presentation often starts with the shortest term rates and extends towards longer maturities. It reflects the market’s views about implied inflation/deflation, liquidity, economic and financial activity and other market forces.

Why Are Yield Curves Important?

The yield of bonds increases with the time to maturity, as uncertainty is higher for lenders waiting longer to get their money back, so they want a higher yield along the way. The “normal” yield curve expresses this relationship for current market conditions succinctly.

The yield curve is the standard reference point for other debt instruments. Most are priced on the current market differential from the yield curve for a given maturity and bond rating. Market differentials are published by Moody’s and other services.

The shape of the yield curve has an impact on many fixed-yield instruments. Numerous businesses make money by borrowing at short bond rates and investing at long bond rates. An inverted yield curve, where long bonds (those with maturities further in the future) pay lower interest than short bonds (those with maturity dates closer in time), is taken as a classic indicator of a pending recession. A flat yield curve affects businesses whose profits depend on the differential.

The Federal Reserve Board attempts to fight inflation by raising interest rates. Its action pushes up short-term rates. As long-term rates are mostly influenced by market forces, the immediate effect is to flatten the yield curve.

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Definition Sources

Definitions for Yield Curve are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 13th April, 2022 | 0 Views.