Understanding the Yield Curve

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The yield curve allows fixed-income investors to compare similar Treasury investments with different maturity dates as a means to balance risk and reward. Additionally, investors use its shape to help forecast interest rates.

In this video, we’ll discuss how to calculate the yield curve, identify its different shapes, and explain what these shapes mean.

You calculate the yield curve by plotting Treasuries according to maturity date and yield.

You can use any combination of maturity dates to form a yield curve. For example, you could combine a three-month, one-year, two-year, five-year, 10-year, and 30-year maturities in a single yield curve.

The display of yields across different maturities helps investors measure the risks and potential rewards of Treasuries. Lower yields are typically associated with shorter maturities and higher yields with longer maturities.

But the application of the yield curve extends well beyond Treasuries. Investors also use the yield curve as a reference for virtually all other types of fixed-income investments.

That’s because the actual shape of the yield curve can help provide insight into the future of interest rates.

The yield curve has three shapes: upward-sloping, or positive, downward-sloping, or inverted, and flat.

A positive, upward-sloping yield curve occurs when yields of shorter maturities are lower than yields of longer maturities.

Conversely, an inverted, downward-sloping yield curve forms when yields of shorter maturities are higher than longer maturities.

A flat yield curve results when yields for short- and long-term maturities are roughly equal.

The yield curve is normally in a positive slope because shorter maturities typically yield less than longer maturities.

When the yield curve is in a positive slope, investors might expect economic growth, which can lead to inflation and ultimately higher interest rates.

Higher interest rates are negative for longer maturities, so investors demand a higher yield to compensate for this risk.

But occasionally, yields of shorter maturities are greater than yields of longer maturities so the slope of the yield curve turns negative, or inverted.

An inverted yield curve forms when investors expect economic growth to slow. If economic growth slows, investors might also expect interest rates to fall.

These expectations increase the demand for higher-yielding maturities, which actually drives the yields of longer maturities lower.

Historically, inverted yield curves have been leading indicators of recessions. This was the case well before the financial crisis. Starting in 2006, the yield curve inverted and warned of the coming recession.

Now that you understand positive and inverted yield curves, let’s look at the third shape—a flat yield curve. This shape forms when yields of short and long maturities are roughly equal.

A flat yield curve is usually a transition from positive to inverted, or from inverted to positive.

For example, as the financial crisis took hold, the yield curve transitioned from inverted to flat, and then turned positive coming out of the crisis.

While changes in the shape of the yield curve can be informative, they don’t necessarily translate to taking action in a fixed-income portfolio.

That’s because speculating about the future of interest rates based on the yield curve is risky and can lead some fixed-income investors astray from their goals.

One way to manage changes in the yield curve is to consider diversifying a fixed-income portfolio across maturities, and even among different issuers and credit qualities.

Another way to consider managing changes is aligning time horizons and risk tolerances with appropriate investments.

For example, an investor with a short time horizon and low risk tolerance might invest in a mix of short maturities with high credit quality.

Conversely, an investor with a long time horizon and high risk tolerance might be willing to accept more risk with long maturities and low credit quality.

Another potential solution to managing changes is laddering bonds, which are fixed-income portfolios that can adjust more dynamically to changes in interest rates.

These potential solutions are a few ways to manage changes in the yield curve, while keeping sights set on your investment goals.

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