Everything you should know about the Yield Curve

With changing times and varied preferences, financial markets have been witnessing an influx of various securities. Potential investors are free to pick and choose the most feasible one among the lot.

Considering the lucrative options available, two inevitable characteristics of a security or an investment avenue are time and interest rates. Most investors choose an avenue based on these two factors.

The general rule of thumb states that the longer the funds are invested, the higher is the rate of interest. However, there are exceptions to this. So if you wish to assess the rate of interest a bond would yield at varying levels of tenure, you are at the right place. Today’s article will cover everything that you need to know about the yield curve.

What is a Yield Curve?

Yield Curve is a graphical representation of the interest rates of a bond in relation to its maturity. Keeping other factors constant, a yield curve depicts how the yield rate fluctuates in various time periods, short, intermediate, and long. The interest rates on bonds form a benchmark for most other factors, so it is of utmost importance.

Typically, a yield curve would depict the interest rates over a period of 3 months, 2 years, 5 years, 10 years, and 30 years. This is a seemingly decent spread to understand and analyze the yield rate disparity between bonds.

Types of Yield Curve

A yield curve forms varied shapes based on the change in interest rates. However, there are certain patterns that can be noticed quite frequently. They are:

• Normal yield curve

The general shape of a yield curve, which is an upward moving design, is termed a normal curve. This curve typically signifies that a bond’s interest rates with a shorter tenure are lesser than one with a longer tenure. A normal yield curve indicates economic stability and expansion soon.

• Flat yield curve

This curve is relatively horizontal, nearly parallel to the X-axis. This simply means that the interest rate does not fluctuate much with the increase in the bond’s tenure. This is a trend that usually occurs during the transition between a normal and an inverted curve.

(Source: the intact one)

• Steep yield curve

This curve forms a similar structure to that of a normal curve. The only difference is that a steep curve forms when the long-term yields increase at a quicker rate than that of the short term. This phase helps the bankers the most as it helps them borrow funds at a cheaper rate and lend at comparatively higher prices.

(Source: Moneycontrol)

• Inverted yield curve

A yield curve is termed inverted when the rate of interest declines as the bond tenure increases. In simple words, in instances when the interest bore by a short-term bond is higher than the interest bore by a longer one. This is a red sign indicating that the economy is heading towards a possible recession. Also, such a trend prevents the investors from investing as this concept isn't practically viable.

Why do yield rates fluctuate?

Various economic and non-economic factors exert their impact on the yield rates. The major ones are:

• Economic growth

Economic growth refers to the increased productivity of a nation.. As a country’s economy passes through various business cycles, the interest rates tend to fluctuate accordingly. When the economy witnesses steady growth, the rates are relatively higher. 

• Interest rates

The government uses another tool to control the yield rates. Manipulating the CRR and SLR and decreasing the interest rate of borrowings will directly impact the yield rates of a bond.

• Inflation

Inflation is the increase in the flow of currency in an economy. The government corrects it through open market operations, which also includes increasing the interest rates. This would attract more investors to park their excess funds and thus reduce the flow of currency.

Importance of Yield Curve

The primary purpose of a yield curve is to determine the future interest rates of a bond. The shape is of utmost importance. This eventually helps one assess the current position and also predict the future position of an economy. As the economy journeys through 4 major phases, the yield curve becomes a good indicator to assess the phase.

It also aids in determining the rates paid and charged by banks and other financial institutions. These institutions borrow using their short-term deposits and lend money for a longer period. The difference in rates paid and charged determines their profitability.

Overpricing and underpricing are common factors in the stock market. This could sometimes be misleading too. The investors, using a yield curve, can determine if a stock is overpriced or underpriced. A stock is said to be overpriced if its rate of return lies below the yield curve, and it is underpriced if the former exists at a point above the latter.

Another advantage of a yield curve is that it provides a balance or a trade-off between maturity and yield. This simply means that if the curve shows an upward trend, it is wise for the investor to choose and invest in longer-term funds, indirectly resulting in a larger risk.

Theories that guide the yield curve

Experts have devised various theories to simplify and explain the shape of the yield curve better. We have listed the major ones for you:

• Unbiased Expectations theory

This theory uses the long-term yield rates as a basis to determine the future yield that a short-term bond would provide. This theory provides investors with a series of arithmetic steps to calculate the future yield. However, it suffers from a few drawbacks. It might sometimes lead to an overestimation, and other factors could affect the yield, which this theory does not consider.

• Liquidity preference hypothesis

This theory states that an investor is entitled to an additional premium in exchange for the risk borne. Long-term investments lack the feature of liquidity, and parking funds for a longer period do include some trouble. 

• Preference Habitat theory

This theory states that a rational investor would prefer short-term securities over long-term ones. Therefore, the yield in the long term must be higher to attract investors and maintain a balance.

• Segmented Market hypothesis

Contrasting to the previous point, John Mathew Culbertson, who formulated the segmented market theory, believes that investors are usually indifferent to the maturity period. Their primary focus is on the yield earned. Therefore, the yield curve purely forms based on the demand and supply of a security.

Final words

Though a yield curve is plotted as a continuous curve, data for certain maturity periods might not be available. The curve is then constructed by predicting the missing rates by analyzing the ones available.

Nevertheless, the yield curve is a great tool to summarise and analyze the interest rates among bonds with varying maturities.