Yield curve

The yield curve plots the yields, at a given point in time, of bonds with the same credit quality but different maturity dates. Usually the yield curve compares the yields of government bonds, such as US treasury debt and is therefore used as the ‘risk-free’ benchmark for other debt on the market.

The shape of the yield curve gives us an idea of the expectations of future interest rate changes and economic activity. The yield curve can either be normal, inverted, flat or humped.

When the yield curve has a normal shape, this implies that longermaturity bonds have a higher yield relative to shorter maturity bonds. This makes intuitive sense, owing to the risks associated with time.

An investor should receive higher remuneration for lending his money over a longer period of time.

When the yield curve is inverted, the opposite is true. Shortermaturity bonds have a higher yield relative to longer-maturity bonds.

This is rare but often occurs before a recession, where investors become more risk-averse, and instead of using their capital to start up a business or invest in riskier assets, they prefer to tie up their money by lending to risk-free entities (such as governments). If they think the economy will deteriorate in the future, they will settle for lower rates of return for owning safe debt, and hence will push down the yields of long-term government bonds.

When the yield curve is flat, there is little or no difference between the bond yields across maturities. This could be seen as a transition between a normal and inverted yield curve.

When the yield curve has a humped shape, yields on medium term bonds are higher than rates of short-term and long-term bonds (also known as a bell-shaped curve).

In the case of an inverted, flat, and humped yield curve, investors are not compensated for the risks associated with holding longer term debt securities.