The yield curve represents the yields of bonds across various maturities. It is also called the term structure of interest rates, and the slope of the curve forecasts the resulting economic contraction or expansion due to the direction of the interest rates. Yield curves can take different shapes: a normal upward-sloping curve typically indicates economic expansion, while an inverted, downward-sloping curve suggests a potential economic recession. Investors must go through these different curves to understand how their bonds will perform during certain market conditions.
Types of Yield Curves
The following are all the different types of yield curves and what they stand for.
Normal Yield Curve
A normal yield curve shows higher yields for bonds with longer maturities and lower yields for shorter maturities. An upward-sloping curve indicates that the yield will continue to rise if you leave the bonds for the long term. This curve typically occurs in a stable interest rate environment, where investors can earn higher yields over the long term.
Flat or Humped Yield Curve
A flat yield curve displays a similar yield across every maturity, which indicates uncertain economic situations. However, some intermediate maturities have high yields that may create a hump in the flat curve. These humps generally occur for mid-term maturities for a maximum of two years.
Inverted Yield Curve
An inverted yield curve goes downward where the short-term interest rates exceed the long-term ones. Such curves correspond to economic recession when people expect returns on long-maturity bonds. Those who want to make safe investments during economic downturns avoid short-dated bonds in this curve and go for longer-dated ones. This increased demand raises the price of long-term bonds, thus lowering their yields.
Steep Yield Curve
A steep yield curve usually appears at the beginning of an economic expansion. The economic situation in that period will create low short-term interest rates, but when the economy starts to grow, there will be an increased demand for capital. Long-term bond investors could be locked into low rates, but the returns can be greater if there are higher rates.
Wrapping Up!
A yield curve is a benchmark for debt instruments in the market. The different types of curves can forecast the changes occurring in economic growth and output over time. So, investors can forecast their rates and returns according to these curves. It’s important to note that while an inverted yield curve is not common, it has historically been a strong predictor of economic recessions. And it has always been a warning of economic recession.
FAQs About What is a Yield Curve?
1. How to estimate the yield curve of a bond?
One can estimate a bond’s yield curve by plotting the treasuries according to their yield and maturity date. Use a combination of maturity dates to form your yield curve.
2. Why is the yield curve important?
The yield curve is crucial for investing in debt instruments as it reflects market expectations about future interest rates. Investors can observe these curves and understand how the market changes will affect their investments.
3. Which is the most common yield curve?
The normal yield curve is the most common one since it shows a rise in the yields of long-term bonds, whereas there are low yields for short-term bonds. This curve responds to economic expansion and focuses on better market conditions.
