The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that inflation will erode the value of their asset over a longer period.

The precise shape of the yield curve varies slightly from day to day and can change significantly from one month to the next. If long-term interest rates rise relative to short-term interest rates, the curve is said to steepen; if short-term rates rise relative to long-term rates the curve flattens. One way to think about this is to regard the yield curve as a forecast of future short-term interest rates. Bond issuers and investors, of course, always have the option of repeatedly purchasing money-market instruments rather than making long-term commitments, so a steeper yield curve implies that they expect money market yields to be higher in future than they are now. The yield curve is said to be inverted if short term interest rates are higher than long-term rates. An inverted yield curve is usually a sign that the central bank is constricting the flow of credit to slow the economy, a step often associated with a lessening of inflation expectations. This can make investors in longer-term instruments willing to accept lower nominal interest rates than are available on shorter-term instruments, giving the curve an inverted shape.

The steepness of the yield curve is not related to the absolute level of interest rates. It is possible for the curve to flatten amid a general rise in interest rates, if short-term rates rise faster than long-term rates. it gives examples of yield-curve changes for government bonds in the United States, the UK, Germany and Japan on two days in 2002. In the month between these two days, interest rates in the United States fell at the “long” end of the yield curve, but rose for maturities of less than 12 months. In Germany, rates moved higher all along the curve. In the UK, yields declined for all maturities. In Japan, which had the lowest interest rates ever recorded, rates rose at most points on the yield curve beyond five years, making the curve slightly steeper. Many investors and traders actively sell bonds of one maturity and buy bonds of another as changes in the yield curve alter relative prices. For example, in October 1992 the interest rate on ten-year US Treasuries was 3.5 percentage points above that on two-year Treasuries. By late 1994 ten-year bonds were yielding less than 0.5 percentage points above two-year bonds. Although the prices of both maturities increased, an investor who had sold two-year Treasuries and used the proceeds to purchase ten-year Treasuries in October 1992 would have profited handsomely by playing the yield curve.


In general, investors that buy bonds first make a decision about asset allocation. That is, they determine what proportion of a portfolio they wish to hold in bonds as opposed to cash, equities and other types of assets. Next, they are likely to allocate the bond portfolio broadly among domestic government bonds, domestic corporate bonds, foreign bonds and other categories. Once the asset allocation has been determined, the decision about which particular bonds to purchase within each category is based largely on spreads. A spread is the difference between the current yields of two bonds. It is usually expressed in basis points, with each basis point equal to one hundredth of a percentage point. To simplify matters, traders in most countries have adopted a benchmark, usually a particular government bond, against which all other bonds are measured. If two bonds have identical ratings but different spreads to the benchmark, investors may conclude that the bond with the wider spread offers better relative value, because its price will rise relative to the other bond if the spread narrows.

Changes in spreads indicate which risks are currently most worrying to investors. Consider the European government bond market, where the benchmark has been the ten-year Bund issued by the German government. Until the late 1990s there was a substantial spread between Bunds and the bonds issued by governments in Italy, Spain and several other European countries. However, as 12 eu countries moved towards the establishment of a single currency, the euro, on January 1st 1999, the spreads within the euro zone narrowed. Investors that had purchased bonds with wide spreads against the Bund profited as spreads narrowed. Even at a time of rising interest rates, when bond prices gener-ally decline, traders astute enough to foresee changes in spreads can do well. Spreads can also widen or narrow if investors sense a change in the issuer’s creditworthiness. If a firm’s sales have been weak, investors may think there is a greater likelihood that the firm will be unable to service its debt, and will therefore demand a wider spread before purchasing the bond. Conversely, investors frequently purchase bonds when they expect that the issuer’s rating will be upgraded by one of the major credit agencies, as the upgrade will cause the bond’s price to rise as its yield moves closer to the benchmark interest rate.


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Unknown said…
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