The idea that taking a bigger risk should lead to a bigger reward is one of the foundational truths in our society and economy. For bond investors, the relationship between risk and reward is played out in the relationship between a bond's yield (which is tied to interest rates) and the length of time until the bond's maturity.
One of the risks of holding a bond is its exposure to inflation. Essentially as prices increase, a bond’s value is diminished because the purchasing power that can come from it is reduced. As consumers, we understand that if we were going to buy $100 of groceries today it would buy more than using that same $100 to buy groceries a year from now. This is due to inflation. The prices of good generally increase so our dollar doesn't stretch as far. For example, if inflation increases by just 2% in a year, you would need $102 to buy the same amount of groceries that you could buy for $100 today.
In the bond market, the same relationship applies. If you have a bond that has a fixed yield of 5%, but during the time you hold the bond inflation rises to 10%, the bond that you own has lost some of its purchasing power. This is particularly harmful to investors that are relying on this bond for income.
With that in mind, investors would expect that they would get a higher yield from a 10-year bond than they would from a 2-year bond, and that is generally the case. One of the ways that investors can monitor the relationship between short-term and long-term bond yields is by viewing the yield curve.
This article will explain what the yield curve is, the relationship between interest rates and bond yields, and the different kinds of yield curves and what they say about the economy, and trading strategies using the yield curve.
What is the yield curve?
The yield curve is a visual representation of the relationship between bond yields and the maturity length of different bonds. The most common yield curve plots the three-month, two-year, five-year, and 30-year U.S. Treasury debt. By monitoring the yield curve, analysts can get a sense of the direction of other debt such as mortgage rates or bank lending rates. It has also been a symbolic, but accurate, predictor of changes in economic growth.
It's important to note that the yield curve is only a snapshot. Although it has been a fairly accurate predictor of slower economic growth, it should not be treated as an absolute predictor.
The relationship between interest rates and bond yields
Interest rates and bond yields have an inverse relationship. That means that as interest rates rise, bond yields will tend to fall. When interest rates decline, bond yields tend to rise. The yield curve is a visual representation of this relationship. It’s also one of the reasons that when the inverted curve starts to flatten, and particularly when it becomes inverted, it has been a fairly accurate predictor of recession. However, the yield curve does not indicate causation.
Types of yield curves
One of the benefits of the yield curve is that it is impossible to misread. When short-term and long-term bond yields begin to narrow, it’s very easy to see as the curve will flatten and, should short-term rates move above long-term rates, the yield curve will become inverted. Let’s take a closer look at what each of these kinds of yield curves represents.
Normal Yield Curve - A normal yield curve slopes up indicating that longer-term bonds have higher yields than shorter-term bonds. This is the kind of yield curve that generally signals an economic expansion. The market dynamic behind this kind of curve is rising interest rates. Rising interest rates affect the psychology of bondholders because, in a growing economy, investors are less likely to have their investment dollars tied up in long-term bonds because of the potential inflation risk. Plus, in a rising interest rate environment, stocks and other securities look more attractive.
As a result, investors tend to flock toward short-term bonds. As this demand increases, yields on short-term bonds go down. This will cause the yields on these bonds to move lower which increases the slope of the yield curve.
Inverted Yield Curve- An inverted yield curve is the opposite of a normal yield curve. Instead of sloping up, it slopes down indicating that short-term bonds have a higher yield than long-term bonds. This is the kind of yield curve that has been a fairly accurate predictor that the economy is contracting, and can be a harbinger of a recession. If investors see long-term bond yields moving lower, they will look to purchase them before rates drop further. Also, when there is evidence that the economy is contracting, the safety of bonds becomes more appealing to investors. The increasing demand for long-term bonds pushes their prices higher but makes their yields lower.
Flat Yield Curve- A yield curve doesn’t move from a normal shape to an inverted shape overnight. As the curve moves from one extreme to another, it will experience times when it flattens out. This indicates that there is some form of transition happening in the economy. In a slowing economy, the yields on long-term bonds will start to decline while yields on short-term bonds tend to rise. When the economy is coming out of a recession, short-term bond yields tend to fall and long-term bonds tend to rise.
How analysts view the yield curve
As we’ve stated previously, the yield curve has been a predictive indicator of a slowing down in our economy. This is because the yield curve is tied to interest rates. When the economy is expanding, banks use short-term borrowing (from depositors or bank-to-bank lending) to fund the loans they make (business, home loans, etc.). When long-term interest rates are higher than short-term rates, it is seen as a sign that lending is profitable. It also implies that access to credit is plentiful.
The opposite is also correct when credit markets tighten, banks become less likely to lend which is typically when long-term rates go down and the yield curve starts to flatten. This is one reason why investors see a flattening or inverted curve as a signal that the economy is entering into recession. In fact, prior to every recession since World War II, the yield curve has inverted.
However, the yield curve is usually also a reactive indicator. This means that changes to the yield curve typically occur after some other event or string of events. Some of which are recessionary, and some which are not. For example, the late 1970s and early 1980s were marked by surging inflation. Plus, the Federal Reserve raised short-term rates which are already at 11% up to over 21%. Another example happened about a decade later in December of 1988. Here the yield curve inverted when several banks and other lenders failed due to the speculative lending that was prevalent in this period highlighted by leveraged buyouts. The pressure on the economy was enhanced by the Iraq invasion of Kuwait that led to concerns about higher oil prices.
Another way the yield curve reacts to changes is when the Federal Reserve makes a change to the federal funds rate, which can affect yields. These moves, however, are usually telegraphed – and some might even say choreographed so that the markets have largely absorbed the effect of the interest rate adjustment before they happen.
Investing strategies using the yield curve
The typical yield curve that is displayed on financial news sites is measuring the bond yields of U.S. Treasury bonds. This gives investors a like-versus-like comparison since federal government bonds have an extremely low default risk due to the fact that the monetary supply could be increased in the event that there was a danger of a default. But for investors that may have exposure to the broader bond market, it is useful to look beyond the typical yield curve. One strategy for analyzing what is going on with bond yields is to compare different sectors (corporate bonds versus Treasury bonds) or quality of bond (i.e. the bond rating). To profit from this analysis, you need to research the typical spread between different instruments.
For example, the typical spread between a 91-day U.S. Treasury bill and a 3-month certificate of deposit issued by a bank is about 0.40 percent (typically referred to as 40 basis points). If an investor sees this spread increase to 0.70 percent, that would suggest that a bank CD would be a better investment. But if the spread between them narrows to around 0.20 percent, it would make the Treasury bills a better option. This spread will be different depending on the length of the bonds that are being compared.
Another strategy for trading using the yield curve is to “ride the yield curve”. This technique is typically only used with normal (i.e. upward sloping) yield curves. In this strategy, investors buy a bond with a longer term than they plan to hold it. They then sell the bond at the date they had initially desired. In this way, they get a higher total investment return because they earn a high interest rate on the bond at the time they purchase it, plus they get a capital gain when they sell the higher return bond.
The bottom line on the yield curve
The yield curve is one of the most often discussed technical indicators of economic expansion or contraction. In its simplest terms, the yield curve shows the relationship between bond yields and the length of maturity for different bond instruments. The most common yield curves show the relationship between different U.S. Treasury bonds.
There are three types of yield curves. A normal, or upward sloping, yield curve signifies an economy that is growing. In a normal yield curve, short-term bond yields are lower than long-term bond yields. This signifies that there is more demand for short-term bonds thus driving up their price and driving down their yield. When there is an inverted yield curve, short-term bond yields are higher than that of long-term bond yields. This has been an accurate predictor of recessions because it generally signifies a tightening of the credit market. Prior to the yield curve being normal or inverted the curve generally flattens showing yields moving closer to each other.
Although the yield curve has tended to accurately predict an economy that was moving into recession, it is an indicator that reacts to other indicators. In this way, changes to the yield curve are often telegraphed long before they happen.
Bonds are part of a diversified investing strategy. Traders can use the yield curve to discover what length of bonds to invest in. Also, bonds and stocks tend to move in opposite directions so when long-term bond yields are declining, it may signal a good opportunity for investors to look at stocks for a higher rate of return.