Yield Curves, its directions & implications for Investors
What are bonds: A bond is a debt security that represents a loan made by an investor to a borrower, usually a corporate or Govt. entity - The borrower agrees to pay interest at a specified rate on specific dates and the principal back as well
Different kinds of Yield Curves: Flat, Inverted, Normal/Rising.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are 3 main shapes of yield curve shapes:
1. Normal (upward sloping curve)
2. Inverted (downward sloping curve)
How a Yield Curve Works
A yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. Yield curve rates are usually available at the Treasury's interest rate websites by 6:00 p.m. ET each trading day. A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of an upcoming recession. In a flat or humped yield curve, the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition.
The yield is what the investor earns per year - Assume Rs.8 is paid per year on a bond worth Rs 100 currently, thus 8% is the Yield. Later on yield is determined using current market price of this bond.
If you are lending money to someone for 3 months v/s say 5 years, the rate of interest will vary. For 3M it will be less and for 5Y it will be more
The yield curve is a graphical representation of the yields on bonds (same credit quality) of different maturities We can see 6m, 12m,1y,2y, up to 40y yields Shape of the yield curve gives insights into the market's expectations for future inflation, rates, economic growth
Normal yield curve
A normal or up-sloped yield curve indicates yields on longer-term bonds may continue to rise, responding to periods of economic expansion. A normal yield curve thus starts with low yields for shorter-maturity bonds and then increases for bonds with longer maturity, sloping upwards. This is the most common type of yield curve as longer-maturity bonds usually have a higher yield to maturity than shorter-term bonds. A normal yield curve implies stable economic conditions and should prevail throughout a normal economic cycle. A steep yield curve implies strong economic growth in the future—conditions that are often accompanied by higher inflation, which can result in higher interest rates. Long term bonds have higher yields than short term bonds - Considered a sign of a healthy economy as it indicates that investors are optimistic about the future & are willing to take more risk (interest rate risk, credit risk, etc) for more returns
Normal Yield Curve Example (aka Rising Yield Curve) - India Look at the 6M Ago (orange dotted line) Yield curve Long term bond yields >> Short term bond yields
Investor sentiment controls the curve: When investors think economy is in good shape, they take out money from long term bonds & put it in riskier assets such as stocks - Lower demand of bonds causes prices to fall and yields to rise (Inverse relationship) Example -
Flat Yield Curve
A flat yield curve is defined by similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve. These humps are usually for the mid-term maturities, six months to two years. As the word flat suggests, there is little difference in yield to maturity among shorter and longer-term bonds. A two-year bond could offer a yield of 6%; a five-year bond 6.1%, a 10-year bond 6%, and a 20-year bond 6.05%.
Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might appear at times when the central bank is expected to increase interest rates. In times of high uncertainty, investors demand similar yields across all maturities.
In a flat yield curve, the yields on bonds with different maturities are similar - Indicates that investors are uncertain about the future direction of the economy Example is India - 6M yield - 7.4% | 30Y - 7.5%, 40 y- 7.5%
A flat yield curve may arise from a normal or inverted yield curve, depending on changing economic conditions - When economy is transitioning from expansion to slower development or even recession, yields on longer bonds tend to fall and yields on shorter ones likely rise.
Inverted yield curve
An inverted yield curve instead slopes downward and means that short-term interest rates exceed long-term rates. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to become even lower in the future. Moreover, in an economic downturn, investors seeking safe investments tend to purchase these longer-dated bonds over short-dated bonds, bidding up the price of longer bonds driving down their yield. An inverted yield curve is rare but is strongly suggestive of a severe economic slowdown. Historically, the impact of an inverted yield curve has been to warn that a recession is coming.
Shorter-term bonds have higher yields than longer-term bonds - This is often seen as a warning sign of an economic recession or slowdown because it suggests that investors have a pessimistic outlook on the economy's future prospects.
What do investors do when they are uncertain about the future? - They may prefer to invest in long term bonds to lock in rates (plus when rate cut cycle starts, bond prices will increase) + they will avoid risky assets such as equity.
Long term bond instrument buying leads to increased demand & higher prices but lowers yields & hence the Curve inverts! - Whenever yield curve inverts, a recession period (marked in red) may follow.
Inverted Yield Curve Example - USA #1 - As of Today #2 - Across different time periods (wanted to show the curve changing from rising to inverted)
Factors Influencing the Yield Curve:
· Inflation Expectations
· Economic Growth
· Interest Rates
· Central bank measures
· Investor preferences
How to Use Them in Investing
One can keep a track of it - one can also track bond yields of listed companies - Bond markets will tell you before problems arise!
While normal curves point to economic expansion, downward sloping (inverted) curves point to economic recession.
Investors can use the yield curve to make predictions on where the economy might be headed and use this information to make their investment decisions. If the bond yield curve indicates an economic slowdown might be on the horizon, investors might move their money into defensive assets that traditionally do well during recessionary times, such as consumer staples. If the yield curve becomes steep, this might be a sign of future inflation. In this scenario, investors might avoid long-term bonds with a yield that will erode against increased prices.
Conclusion - India's flat yield curve points towards a likely end of rate hike cycle or even steady rates expectation & shows a shift of investors to long term bonds to lock in rates over riskier assets such as equity.
CA Harshad Shah, Mumbai firstname.lastname@example.org