What is A Yield Curve?
A yield curve is an image that shows the relationship between interest rates (yields) and the time to maturity. The curve usually compares short-term bonds to long-term bonds, by putting yield on the y-axis and maturity date on the x-axis.
Any set of bonds from a government, municipality, or corporation can be put on a curve. However, when financial media refers to “The Yield Curve,” they are likely talking about the United States Treasury yield curve. This curve compares U.S. Treasury bonds with different maturities, such as 2-year, 10-year, and 30-year bonds.
Yield refers to the income you earn from an investment, usually expressed as a percentage. In the context of bonds, it’s the return you get on the bond based on the bond’s price and the interest payments. For example, if you buy a bond for $1,000 and it pays $50 per year in interest, the yield is 5% ($50 / $1,000).
Maturity is the length of time until the bond must be paid back in full. For example, a bond with a 10-year maturity will pay interest for 10 years. It then returns your initial investment (the principal) at the end of that period. When you hear about a bond’s “maturity,” it’s referring how long it will take for the bond to fully pay back the investor.
Types Of Yield Curves
Remember, bonds are tricky in the sense that they do not work like equity investments. BOND YEILD AND BOND PRICE ARE NOT THE SAME THING.
As bond prices fall (bonds are sold), yields rise.
As bond prices rise (bonds are bought), yields fall.
We call this an inverse relationship.
The idea here is that if many people are buying a specific bond, it is safer, and therefore it will pay less. If nobody is buying a specific bond, it will yield more, as the market is marking it as a riskier investment.
Normal Curve
This is when long-term bonds have higher yields than short-term bonds, indicating that investors expect a growing economy.
You can think of it like this: Investors are confident in the future of the economy, so they don’t need safe, guaranteed income over a long period of time. They will sell their long term bonds and drive their yield up. Because things are going well right now, investors strive to make money today.
Inverted Curve
When short-term bonds have higher yields than long-term bonds, this can signal that investors are worried about the economy slowing down or a potential recession.
Investors panic, and look to lock in their guaranteed long term fixed income. They buy up long term bonds (driving the yield down) when they feel like the market is in a bad spot and want less risk.
These charts can be a little misleading without numbers on the axis. For example, the latest inversion of the yield curve was in August of 2019. The 2-year yield was 1.634%, while the 10-year yield was 1.623%. This seemingly small difference is a major economic event, as there have only been a handful in recent history.
Flat Curve
When short-term and long-term bonds have similar yields, it often means that the market is uncertain about future economic growth.
Flat curves are interesting in the sense that there is not a simple “One size fits all” explanation to the causes and effects.
As an example, let’s say the Fed raises rates. Let’s also assume the market expects a short period of interest rate hikes followed by rate cuts.
In this scenario, it is possible that short-term yields will rise, because investors demand higher yields to compensate for the increased cost of borrowing. Also, short term yields tend to be very sensitive to central bank activity.
Unlike short-term yields, long-term yields (such as 10-year or 30-year Treasury yields) do not rise as sharply when the central bank raises interest rates for a brief period. This is because long-term yields reflect long-term expectations for inflation, economic growth, and the overall interest rate environment over many years.
Because short term yields are increasing while long term rates remain unchanged, a curve that was once “Normal” is now “Flat.”
Why is the Treasury Yield Curve Important?
Investors look at the treasury yield curve as a gauge of economic health. To put it simply, A normal curve projects strong economic growth, while an inverted curve can be a warning of an economic downturn.
How Does the Yield Curve Correlate with the Stock Market?
A normal yield curve is generally positive for the stock market, including the S&P 500. In this scenario, investors are optimistic about corporate earnings growth, and sectors like financials (banks) tend to benefit, as they can profit from lending at higher long-term rates while borrowing at lower short-term rates.
A flattening yield curve can create mixed reactions in the stock market. Some investors may interpret it as a sign that economic growth is slowing, leading to a more cautious outlook for stocks. Defensive sectors like utilities and consumer staples may perform better during this time, while growth sectors may slow down.
An inverted yield curve can lead to a decline in stocks, as investors become more cautious and anticipate weaker economic growth, lower corporate earnings, and possibly a recession. The stock market may sell off as investors move into safer assets like bonds. Historically, an inverted yield curve has been a reliable warning of a downturn in the stock market.
Can you Profit Off of the Yield Curve?
Yes, bond investors use strategies such as “Riding the Yield Curve”, the “Barbell Strategy”, and the “Bullet Strategy”.
For most of my target audience, it is not worth pursing these strategies, as they are complicated and you likely need a large amount of money to generate a worthy return.
For those interested, here is a brief and simple description for each of the three:
Riding the Yield Curve
- What it is: This strategy involves purchasing long-term bonds and holding them for a shorter period.
- How it works: When the yield curve is normal (with long-term bonds offering higher yields than short-term bonds), investors can buy long-term bonds and sell them after they have gained in price as they approach maturity, earning both coupon payments and potential capital gains.
- When to use: This strategy works best when the yield curve is normal and investors expect interest rates to remain stable.
The Barbell Strategy
- What it is: The barbell strategy involves holding both short-term and long-term bonds but avoiding intermediate-term bonds.
- How it works: Investors buy short-term bonds to take advantage of flexibility and higher yields in the near term, while long-term bonds are held to lock in higher yields over time.
- When to use: This strategy is typically used when the yield curve is flat, as it balances exposure to both ends of the curve to hedge against unexpected changes in interest rates.
The Bullet Strategy
- What it is: The bullet strategy focuses on buying bonds with maturities that are concentrated around a specific date.
- How it works: Investors purchase bonds at different dates, but those bonds all mature on the same date. They hold them until they mature, collecting a lump sum payment on maturity day.
- When to use: This strategy is effective when the yield curve is expected to shift significantly (e.g., flatten or steepen), as it allows investors to spread out risk of interest rate fluctuations over time.
Closing Notes
Similar to many core investing concepts, understanding the yield curve isn’t going to make you a millionaire.
But at the end of the day, it is still a core financial concept. A concept applicable to everyone; whether you are trying to interpret a CNBC headline, or trying to pass a a fixed-income derivatives class in college.
Remember, making deposits in your knowledge bank will compound over time.
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