In the first of a series of articles about ‘yield curves’, this month’s Calculator Corner introduces the concept. In forthcoming months, we will look at its purpose – how treasurers ‘play the yield curve’, explain how it is measured and explore the different ways to construct a yield curve.

What is a yield curve?

A ‘yield curve’ is the line on a graph showing the yields (i.e. the return) from an investment over time. By plotting the yields over different time periods, a yield curve is produced. A yield curve is based on the interest rates paid for different periods. Since short and longer term rates are different, the yield curve provides an illustration of how rates vary over time.

Different maturity dates

A yield curve will cover a range of maturities – perhaps overnight, one week, one month, three months, six months and one year or more. Whilst, for longer-dated instruments, a range of maturities from one to as much as twenty five years might be taken.

In most cases, the yield available on a longer maturity (eg one year or more) will be higher than a shorter dated investment (eg a period of weeks or months). In other words, a premium is paid by the investor for the longer maturity. However, investors may be expecting interest rates to fall, in which case the shorter date may pay a higher yield. This contributes to the shape of the yield curve.

The shape of a yield curve

Yield curves vary in shape depending on three factors:

• Future interest rate expectations.
• Risk premiums on the underlying investment.
• The convexity bias – how the slope of the curve changes over time in relation to other interest rates (a complex subject to which we will return in the future!).

The main types of yield curves are:

• Normal (positive) yield curve

  Where long-term investments have higher yields than shortterm ones. This is the most typical scenario in developed countries.

  In some circumstances, a positive yield curve may be very steep. If the curve does rise sharply, this is usually associated with an economic upturn post-recession.

  

• Inverted (negative) yield curve

  Where the long-term yield is less than the short-term yield. This indicates an expected decline in interest rates.

  

• Flat (even) yield curve

  Where the yield is the same for short-term and long-term debt securities (eg bonds). This is an unusual scenario and can suggest an economic slowdown. A flat yield curve often precedes a change from a positive to an inverted yield curve (or vice versa).

  

• Humped yield curve

  Where the yield is initially higher and later lower. This often indicates interest rates are expected to rise and then fall.