A yield curve is a graphical representation of the current interest rates. The interest rate varies across the maturity. The yield curve shows the rate of return that can be locked in now for various terms into the future. The left, vertical Y-axis of the graph shows the YTM that is currently available in the marketplace. The bottom, horizontal X-axis shows the G-Sec maturity. The yield curve is the line connecting YTM across maturities and looks something like this:
A yield curve can be created for any specific segment of the bond market, from AAA-rated corporate bonds to single-B rated corporate bonds. The G-sec yield curve is the most widely used because G-Sec has no perceived credit risk, which would influence yield levels, and G-sec and T-bill market includes securities of every maturity, from 3 months to 40 years.
As the investor in the Bond, we all know that Yield to maturity reflects the total return an investor receives by holding the bond until it matures. But why the yield curve is important and does it has a predictable power?
The information contains in the yield curve is valuable for the prediction of business cycles, inflation, and monetary policy; the response of the yield curve helps to understand the extent of transmission of monetary policy and, it is also the barometer to measure the impact of any surprises on the macro economy. The importance of Yield curve can also be gauged by the fact that it represents the relationship among short, medium and long-term yield and most of the pricing activity taking place in the bond markets centres around it. The Yield curve is also called Term Structure of Interest Rates. To understand the shape of the yield curve, we must understand the variables of yield curve – level, slope, and curvature.
Level = Average yield of Short Term (3mnths), Medium Term (2years) and Long Term (10years).
Slope = Spread = Difference in the yield of Short Term (3mnths) and Long Term (10years).
Curvature = [2 x Long Term yield (10years) – Short Term yield (3mnths) – Medium Term yield (2years)].
And examine the theories and hypotheses that explain the yield curve and the relationship of short, medium and long-term interest rates:
- Pure expectations: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk.
- Liquidity premium: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk, plus a premium for holding long-term bonds, called the term premium or the liquidity premium.
- Preferred habitat: In addition to pure expectations and liquidity premiums, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their “preferred” maturity, or habitat.
- Market Segmentation: postulates that the yield curve is determined by supply and demand for debt instruments of different maturities.
The Yield curve has five major characteristics:
- The change in yields of different term bonds tends to move in the same direction.
- The yields on short-term bonds are more volatile than long-term bonds.
- The Long-term yields follow the short-term yields.
- The yields on long-term bonds tend to be higher than short-term bonds.
- At a given level, yields are mean reverting.
The pure expectations hypothesis explains the first three characteristics; the liquidity premium theory explains the fourth characteristic and the market segmentation explains the last one.
The Shape of the Yield Curve
There is a dynamic relationship between fiscal and monetary developments – government debt and the budget deficit, real output, inflation and the monetary policy rate– and the shape of the yield curves.
A normal, upward-sloping yield curve suggests the economy will grow in the future, and this may lead to higher inflation and higher interest rates. No one will buy longer-term securities without a higher interest rate than those offered by shorter-term securities. A normal yield reflects the easing of monetary policy and easy liquidity. And the economy expected to expand. The upward sloping normal yield curve is the most common shape of the yield curve.
When the long-term yields fall below short-term yields, the yield curve becomes inverted. An inverted yield curve indicates the economy is to slow or decline in the future and this slower growth may lead to lower inflation and lower interest rates across all maturities. An inverted yield curve typically indicates that central banks are ‘tightening’ monetary policy, limiting the supply of money in the banking system and thus control credit availability. An inverted yield curve has indicated, in the past, the slowing down of economic growth and even recession.
When the short-term bond yields increases and yields on long-term bonds decrease, the yield curve flattens or appears less steep. A flattening yield curve can indicate that expectations for future inflation are falling and thus the demand higher long-term bonds fall. Since inflation is less of a concern, the long-term premium shrinks. A flat yield curve indicates a slower economic growth.
A humped yield curve is a kind of flat yield curve or reflects uncertainty about specific economic policies or conditions, or it may reflect a transition of the yield curve from a normal to inverted or vice versa.