UNDERSTANDING YIELD CURVES

"Yield Curve", the most frequently used term among Fixed Income Investors is a curve that plots interest rates on the vertical axis & their respective periods on the horizontal axis. The periods represented vary across different maturities of fixed income securities such as 5-year, 10-year, 15-year, 20-year, etc. having the same credit quality. Analysts popularly use Yield Curves to compare the rats across different maturity bonds.

Now we know that the yield curve is a graphical representation of yields on the y-axis and their respective maturities on the x-axis. Analysts and Fixed Income investors use the Treasury bond yield curve as a benchmark for their securities. The yield curve is also useful in forecasting the growth of the economy. This makes the shape of the yield curve an important factor in credit analysis. A yield curve can usually take these four shapes:

Normal or Positive Yield Curve A normal or positive yield curve reflects that yield continues to rise with maturity. Longer the period higher the yield. This is a sign of economic growth & expansion. The normal yield curve also suggests future inflation. The name positive is derived from its positive slope. We can clearly see that long-term bonds will have a higher yield than short-term bonds. So in such a scenario investors should invest in short-term bonds rather than long term as the value of long-term bonds will decline.

Inverted or Negative Yield Curve An economy experiences a negative yield curve when yields on long-term bonds are less than yields on short-term bonds. This is a sign of economic recession. In this type of scenario, investors should go for longer-term bonds as their value will increase because of declining yield. Inverted yield curves are very rare phenomena but there is empirical evidence that a recession follows an inverted yield curve. A negative yield curve also happens when Fed increases the rate to check the overheated market.

Flat Yield Curve An economy witnesses a flat yield curve when both short & long-term bonds provide equal yield. This signifies that the investors do not receive extra compensation for holding long-term bonds. A flat yield curve is usually a signal of declining inflation. A flat yield curve is usually experienced during the transition phase between positive & negative yield curves. During November 2017 rising Fed rates sent a strong signal of flattening of yield curves.

Humped or Walking Stick Curve A humped-shaped yield curve is also called a walking stick yield curve because of its shape. The main characteristic of a humped yield curve is that the yield for a term remains unchanged but falls on either side of it.

Let's Discuss the Shift in Term Structure

We already know now that term structure signifies yield at different maturities of the same quality bonds. We have also seen the different shapes that a yield curve can take, but what is more relevant from an investment point of view is the change. These changes in the yield curve are known as shifts in the term structure. The changes in the yield curve occur due to changes in the yield of short-term & long-term bonds. There are basically three types of shifts, they are:

Parallel Shift A parallel shift in the yield curve occurs when all the rates in the term structure increase or decrease in the same direction and by the same mass. In the above scenario, the curve shifted upwards by 200 basis points. In a parallel shift, the shape and slope of the yield curve remain unaltered. This is the most common type of shift seen in a normal yield curve.

Flattening Shift - Convexity change Flattening Shift occurs when the spread between the yields of long-term bond narrows. Flattening shifts are of two types: Convexity change & Twist The above two diagrams are examples of convexity change. In convexity change, the shift in both long-term and short-term occurs in the same direction but with a different magnitude. In both the diagrams, there is a significant change in short-term rates but a very meager change in long-term rates which forced the yield curve to flatten.

Flattening Shift - Twist The below diagrams represent flattening twist shifts. In a twist shift, the short-term and long-term rates change in the opposite direction. In the left-hand side figure long-term rates have fallen whereas short-term rates have risen which has decreased the slope of the yield curve thereby flattening it and vice versa for the adjacent figure. A flattening shift occurs in a clockwise direction. In a normal economic scenario flattening of the yield curve is an indication of falling interest rates.

Steepening Shift - Convexity change Steepening shift occurs when the spread between the yield of long-term & short-term bonds widens. It is just the opposite of flattening. Steepening shifts are also of two types: Convexity change & Twist. The above two examples are of convexity change. Just like flattening, in the convexity change of steepening also the shift in both long-term and short-term rates occurs in the same direction but with a different magnitude. In both examples, there is a significant change in short-term rates but very little change in long-term rates which forced the yield curve to steepen.

Steepening Shift - Twist change The below scenario explains steepening twist shift. In both examples, the difference between short-term and long-term rates has increased thereby steepening the curve. However, the direction of the change of short-term & long-term rates is different. Steepening of the yield curve occurs in an anti-clockwise direction. In a normal economic scenario of rising yields steepening of the yield curve signals increasing inflation & strong economic growth.

Evolution of the Yield Curve from 1990 to 2022, one of the best predictors of a looming recession. The description of what was happening during each time frame is on the right.