A yield curve shows the return that investors in a bond, or gilt, expect to get over a fixed period.
The yield curve, which is a graphic representation of bond repayments over the maturity of the debt instrument, typically reflects the relationship between anticipated interest rates and bond maturities, or in other words, how much it costs to borrow over different periods of time.
The horizontal axis shows the time remaining until a bond is repaid, known as the bond’s maturity, and the vertical axis shows the yield, defined as the annual ‘coupon’ rate of interest.
Typically, the shorter the maturity or term of repayment on a bond, the lower the yield, indicated by the amount to be repaid set by the coupon rate, on the bond.
In normal conditions, bonds with longer maturities will have higher yields, meaning they will reap more over a longer period. The longer the maturity date, the longer it will take the issuer, such as the government in the case of a gilt or government bond, to repay the debt.
Since the issuer, for example the government, will take longer to pay out repayments to bondholders over the lifetime of the bond, yields are often priced higher to compensate for the higher risk of lending over a longer period.
The reverse is also true.
That means that the longer time it takes for a bond to mature, typically the higher the yield as investors demand more compensation to reflect the greater risk they are taking over time.
According to Fidelity, a yield curve is a visual depiction of the market’s expectation of interest rates and economic conditions, or risk, that gives investors an idea of the amount they can expect to receive in return for their investment.
The US Treasury yield curve, which shows the yields of US Treasuries with different maturities, is often used as a benchmark that sets the tone for the sort of yields that can be expected from a bond over a period of time.
The Bank of England also produces two types of estimated yield curves for the UK on a daily basis: including a set based on yields on UK government bonds, also known as gilts, and a set of estimated yield curves based on sterling overnight index swap (OIS) rates.
Normal yield curve
A typical or normal yield curve is sloped upwards from left to right as yields rise in line with maturity – normally becoming less steep as time goes on, reflecting a normal economy where interest rates are predicted to be relatively stable.
But yield curves are affected by supply and demand.
So – bearing in mind that yields move inversely to prices – if there is high demand for a bond then the price typically increases, resulting in the yield falling. And if there is low demand then the associated price falls and yields rise.
Steep yield curve
In times where inflation and interest rates are expected to rise, a yield curve can steepen as buyers of bonds, who are effectively lenders of debt, seek higher compensation and rates for their longer-term investment.
While the coupon rate is fixed, the secondary price of the bond can change depending on market conditions.
Inverted curves
In a similar way to when house buyers seek to lock in fixed rate mortgages, or loans, to avoid fluctuations in interest rates, sometimes investors want to lock in the current rate of interest if rates are expected to fall.
That can lead to a so-called inverted yield curve, which often anticipates an economic slowdown, where yields of shorter-term bonds are higher than the yields on longer-term bonds, which are priced in at lower rates than usual over the long term.
A yield curve can also depict a hump, where short-term rates of interest are predicted to rise and yields are expected to peak and trough in line with those base rates.
This means that if there is significant demand for longer-rated bonds, for example where pension funds want to match their fixed liabilities, then the prices are expected to be high, resulting in low yields.
Yield versus price
A coupon on a bond is fixed, though the price of a bond can vary when it is sold, meaning the market price can rise and fall despite its coupon.
When interest rates rise, the so-called yields on newly issued bonds also often rise. This is because the repayment rate, the rate at which the issuer promises to repay the debt, is broadly set in line with the rate of interest.
However, when yields rise, the price it costs to buy or invest in a bond on the secondary market can drop. This is caused by market dynamics and factors such as investors selling off older, lower-yielding bonds and replacing them with higher-yielding, new ones when rates rise.
Such a glut in the market can cause the price to fall.
When the secondary market price of a bond falls, the yield typically rises, and the inverse is also true. That is because the bond’s yield represents the discount between its cash flow and its dollar price.