In our second article on yield curves, we look at the purpose of a yield curve and the different situations in which it may be used.

Benchmarking

Higher-risk securities will pay more interest, which means they give a higher yield than those that involve less risk, such as government bonds. Investors can, therefore, use the yield curve of a relatively safe security as a benchmark for the increased return they might expect to receive on a riskier security. By comparing the two curves the additional yield for different periods can be compared.

Pricing bonds and other interest bearing securities

Forecasters can use interest rate forecasts to try and predict what will happen to yield curves in different scenarios. The value of interest bearing securities are determined by a number of factors, including the present value of their expected yields, so yield curves can be used by investors to identify which bonds may be comparatively cheaper than others and therefore represent good investment potential.

Maximising returns

The shape and movement of the yield curve are used by investors to identify the optimum time to invest. This is referred to as ‘playing the yield curve’ or ‘riding the yield curve’. There are many strategies that investors follow when attempting to maximise returns on their yields; the following are two of the more common examples:

Investors use a barbell strategy for buying securities at extreme ends of the yield curve – short-term and long-term securities. This enables investors to make the most of attractive long-term interest rates, while hedging the risk with short-term securities in case the market takes a downturn. The return from the short-term securities is usually reinvested, again on a short-term basis, after maturity. The barbell strategy is usually most successful when the yield curve is flat.

The bullet strategy is used to build a portfolio of securities that all mature at a given point on the yield curve. This is a useful strategy when investors know they will need the funds at a particular time, but want to stagger the investment to reduce the risk. This is usually more successful when the yield curve is rising steeply.

Forecasting economic conditions

Investors might also use yield curves as indicators of future economic trends. Since yield curves reflect market sentiment – and market sentiment can impact on the wider economy – they may indicate a tendency towards recession or an economic upturn.