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Yield Curve

Bonds

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Curriculum Content

The yield curve shows rates of borrowing in relation to periods of time. It specifically shows differences in the short term and long term yields. There are multiple yield curves, but government bonds are the most closely tracked, since they set interest rate trends. They are the basis of “risk free” investment rates for a local market.

The Yield Curve itself has a vertical yield axis, a horizontal time axis, and a curve displaying yields as they relate to time. Rates generally increase over the length of the term. The steepness of the curve indicates the increase in yield a bondholder can receive buying longer terms. This increase is often necessary. You need a reward to offset the greater risks you will encounter from loaning money long term. A lot of problems can occur over the course of 10 to 30 years. Central banks can raise rates, bond values can decrease, firms can default, and economies can crash. A higher yield for a long term bond reflects these possibilities, and compensates you for taking them.

This may lead you to believe a yield curve will always increase in steepness. It does not. Sometimes, the yield curve will be flat. There will be no additional reward for long term bonds compared to short term bonds in the category. Even more strangely, in rare situations short term bonds actually return higher yields than long term bonds. This is known as an Inverted Yield Curve.

You’d be inclined to believe that there’s no benefit possible to investing in midterm or long term bonds if the yield curve is flat or inverted. That’s incorrect. When a financial crisis or uncertainty occurs, the market seeks shelter in bonds or commodities (such as oil, gold, and diamonds). The demand raises the price of these asset categories. Central banks usually lower interest rates to accelerate economic growth which increases the market price of existing bonds above the new rates.

Long term bonds and midterm bonds may see larger increases in market price than short term bonds due to their higher price volatility. The benefit to having purchase those bonds after a lowering of interest rates will be the profit from sales after the value of those long term bonds increases. Additionally, if rates have dropped you will be forced to buy lower yields as your existing short term bonds come due. If you didn’t buy long term bonds you would be forced to reinvest your short term bond maturities into lower interest rates. Your orientation towards purchasing long term bonds with flat or inverted yield curves should be approached based on the market situation.

Note that in most cases, the 5 year yield is below the 10 year yield, which is below the 20 year yield. When inverted, the 5 and the 10 year yield are both higher than the 20 year yield. Flattening occurs when all the yields begin to merge together, and inversion occurs when the 5 year rises above the 10, which rises above the 20.

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