Introduction To Bonds - Understanding The Yield Curve

The Financial Press tends to talk about market interest rates as if some monolithic reference rate existed. This is obviously not the reality. In fact, different maturities almost always carry different interest rates. Furthermore, different credit classes also carry different interest rates. All of these rates tend to move in the same direction, but that is not always the case. In addition, different maturities may move the same direction but different amounts. The Yield Curve is nothing more than a graphical depiction of the relationship between yield and maturity at a given point in time. A Yield Curve is a market snapshot.

Most commonly, the Yield Curve depicted is the one for US Treasury Securities. Yield Curves can have many shapes. A "Normal" Yield Curve is the most common shape. Normal curves are characterized by a gently upward sloping shape. Shorter maturities, on the left-hand side of the curve, carry lower interest rates than longer maturities, located on the right hand side of the chart. Investors are compensated, through receiving higher interest rates, for putting their money at risk for a longer period of time. The higher the perceived risk, due perhaps to expectations of inflation, the steeper the curve will be.

At times the Yield Curve can take on an "Inverted" shape, with shorter maturities carrying higher rates than longer maturities. Long-term investors are sometimes willing to settle for lower rates if they believe all rates will decline in the future. They are thus able to lock in what they consider to be attractive rates for a longer period of time. Inverted Yield Curves are considered precursors of economic slowdown or even recession. They are, in fact, typically followed by lower interest rates across the board.

Between these two extremes are "Flat" or "Humped" Yield Curves. Yield Curves of these shapes are often intermediate steps achieved as the Yield Curve moves towards or away from inversion.