What is a Yield Curve?

By Kevin Chambers

A yield curve is a graph that shows the interest rates of bonds that have different maturities. The bonds are all the same credit quality. The curve is used to isolate the effect of the length of payment on interest rates. The most common yield curve commented on by the financial media is the yield curve for US treasuries. The US treasury yield curve is analyzed as a benchmark for interest rates in general. The yield curve shape can also give clues to what investors are expecting in the future.

Shapes of a Yield Curve:

Normal:

The standard theory of bond investing assumes that investors are acting rationally. Therefore, under normal circumstances, the longer an investor’s money is tied up in a bond, the higher interest they would require. Therefore a normal curve has higher interest rates for the longer maturity bonds. 

Inverted:

An inverted yield curve is the opposite of the normal curve. Short-term maturities have higher interest rates than the longer term bonds. This indicates that investors have a negative outlook on the future economy. Investors are so worried about other asset classes, they are willing to pay lower interest rates for safe and essentially guaranteed long term bonds. 

Flat:

A flat yield curve means there is no difference between the yields of short maturity bonds and long maturity bonds. This usually happens in transition periods between yield curves. 

Current Yield Curve:

As of the end of June 2015, the yield curve for US Treasuries is below:

Because of the actions of the Federal Reserve after the 2008 crisis, the low end of the curve is at essentially zero. One- to six-month treasuries are yielding 0.1 currently. Yields then steadily climb to around 3.0 for the longest maturity bonds. The curve currently is pretty normal, but at historic lows. The yield curve for US treasuries is a benchmark of sorts. It shows what interest rates could be expected of other products. Changes in yields in US treasuries are usually reflected in mortgages, corporate bonds, and other debt instruments. At Headwater Investments, we watch the yield curve closely to keep a watch for changes and to better analyze our fixed income positions in our portfolios.